Oct. 27 (Bloomberg) -- A rebound in the U.S. dollar is the biggest risk for Latin American stocks as they head for their steepest rally in nearly two decades, Citigroup Inc. said.

The dollar may rise against regional currencies early next year as investors anticipate an increase in U.S. interest rates by the Federal Reserve, Citigroup strategists Geoffrey Dennis and Jason Press wrote in a note to clients. There has been a “tight correlation” between a falling dollar and rising Latin American equities since 2002, they said.

The MSCI Latin America Index has gained 85 percent this year, the most since 1991. Brazil’s Bovespa index has rallied 68 percent in 2009 while the real appreciated 33 percent against the dollar, the most among the 16 most-traded currencies.

“The biggest fundamental risk of a decent correction in regional equities is, therefore, a bounce in the dollar,” the strategists wrote. “As markets enter 2010, the timing of the first Fed move will come closer and the dollar could bounce, triggering a more severe correction in regional equities.”

The Fed may start increasing borrowing costs around the middle of 2010, accelerating the dollar’s gains, the strategists wrote. A similar scenario in the second quarter of 2004 preceded a 22 percent fall in the MSCI Latin America Index, they said.

The dollar has dropped 12 percent in the past year against a basket of six major currencies as the Fed, led by Chairman Ben S. Bernanke, cut rates to near zero in an effort to lift the U.S. economy out of its worst recession since the 1930s. New York University professor Nouriel Roubini said the dollar will eventually “bottom out” as the Fed raises borrowing costs and withdraws stimulus measures.

Valuations

Emerging-market stocks dropped the most in two months today after India’s central bank increased its inflation forecast and ordered lenders to keep more cash in government bonds, spurring speculation Governor Duvvuri Subbarao will raise borrowing costs by year-end.

The MSCI Latin America index’s 6.6 percent slide in the last six days isn’t cause for concern and prospects of a multi- year bull market are supported by a recovering global economy and “sound fundamentals” in the region, they wrote.

“Valuations are not a concern as prices typically move ahead of earnings early in a bull market,” Dennis and Press wrote. “Investors should buy any corrections.”

Brazilian stocks are inexpensive even after this year’s Bovespa rally and cutting allocations may be “hazardous” for investors, Goldman Sachs Group Inc. said. The Bovespa may top 85,000 by the middle of next year, Stephen Graham, a Sao Paulo- based analyst wrote in a note distributed yesterday.

Underweight Mexico

A “correction” in Latin American equities is more likely early next year than late this year, the Citigroup strategists wrote, reiterating a preference for Brazil over Mexico.

They kept Mexican stocks “underweight,” citing the risk of a sovereign credit rating downgrade after the government’s 2010 revenue proposal was “severely watered down.”

To contact the reporter on this story: James Attwood in Santiago at Jattwood3@bloomberg.net

Last Updated: October 27, 2009 17:15 EDT