By Wanfeng Zhou
NEW YORK, July 6 (Reuters) - The divergence between the U.S. dollar and Treasury yields seen for much of the second quarter is likely to continue, and may be a sign that the greenback's days as the world's safest currency are numbered.
Often, rising U.S. yields are followed by dollar strength because higher rates make the currency more attractive to overseas investors.
But that hasn't been the case since March. In the second quarter, the dollar dropped more than 6 percent against a basket of currencies <.DXY>, its first quarterly decline since early 2008. Yields on 10-year Treasuries, on the other hand, have risen by more than 0.8 percentage point, the biggest quarterly gain since at least 1998.
The breakdown in the relationship, while in part reflecting an unwinding of safe-haven flows into dollars and Treasuries on recovery hopes, could signal that investors' confidence in dollar assets has waned because of worries about rising deficits and weak economic growth.
"Right now, we think we're in a cycle where the perception of the dollar as a risky currency has gone up," said Steven Englander, head of currency strategy in North America at Barclays Capital in New York.
RISING RISK IN THE DOLLAR
Concerns about the inflationary impact of debt monetization in the United States and a potential devaluation of the dollar have grown sharply since the Federal Reserve announced in March a plan to buy $300 billion of Treasuries. That has hit the dollar hard even though yields remain more attractive than in March.
"Investors may be pricing in a greater risk premium ... into Treasury securities," said Sacha Tihanyi, currency strategist at Scotia Capital in Toronto. "These include higher fiscal deficits and riskier monetary policy, which may help stoke inflation if not properly managed."
Some foreign nations have scaled back purchases of long-term U.S. assets because of worries about deficits, and some, like China and Russia, have challenged the dollar's role as the global reserve currency.
Chinese officials, in comments published on Monday, asserted that the world should look to displace the dollar even if that will take many years. The push comes just before the Group of Eight summit in Italy this week. Other sources told Reuters that Brazil and India backed Beijing's call. [ID:nL2198823].
"There's a decidedly negative psychology against the dollar right now, most of which is underlined by the renewed jaw-boning from Chinese officials," said Ashraf Laidi, chief market strategist at CMC Markets in London.
FINANCING WORRIES
With the U.S. government on course to bring $2 trillion in new bonds to the market this fiscal year, worries over the United States' ability to finance its deficits will continue to limit the dollar's potential gains and put upward pressure on yields, analysts say.
The dollar will likely fall to around $1.55 to $1.57 against the euro by year-end, according to CMC Markets' Laidi. He expects the rising trend in Treasury yields to remain intact.
"The Fed's Treasury purchases weighed on the dollar but failed to reverse the yield rally," he said. "We could expect a continuation of the inverse relation between yields and the dollar."
Analysts say U.S. growth will remain subdued in the near future, limiting the Obama administration's ability to reduce its fiscal deficit. Meanwhile, the risk aversion since the collapse of Lehman Brothers has dissipated, and the expectation of low interest-rate targets from the Federal Reserve won't make U.S. assets more attractive, either.
"While U.S. rates will be higher than European rates, relative to the perception of risk surrounding the Treasury issuance and the quantitative easing and the pace of growth in the U.S. economy, the rate differential won't be enough to attract sufficient capital to keep the dollar stable," said Barclays Capital's Englander, who sees the dollar trade at $1.50 against the euro in 12 months time.
On Monday, the euro was last little changed at $1.3963