By Natsuko Waki
LONDON, Dec 21 (Reuters) - Currency markets are becoming a new source of concern for investors as worries over the tumbling dollar and sterling replace a relief that world stocks may have bottomed with a 20-percent rise since November.
The dollar lost more than 6 percent against a basket of major currencies so far this month, heading for its biggest monthly fall since 1985, after the Federal Reserve cut interest rates to near zero and pledged to take more easing measures.
A domino effect has hit sterling, which fell to record lows versus the euro near parity and on a trade-weighted basis as investors bet the Bank of England would follow the Fed into slashing the cost of borrowing towards zero.
Evidence of further deterioration in the United States and Britain -- the two major casualties of the credit crisis -- has unleashed a race to cut interest rates to zero.
"We know the next step for the Fed will be to print money. The side effect of monetary financing in the U.S. is a flood of dollar supply and that will... add to the weakness of the dollar more than people expect," said Wim Boonstra, chief economist at Rabobank.
"You will see a global scheme of monetary financing. If countries turn to monetary financing to try not to have a stronger currency... If that scenario materialises we will enter very dangerous territory."
With major policy interest rates more or less converging at the extremely low level of Japan, Barclays Capital reckons interest rate differential as a driver of currency returns is likely to take a back seat for the first time since 2005.
"Radical fiscal stance will emerge as the dominant driver and countries with a bigger deterioration of their fiscal positions generally will have weaker currencies," it said.
This week's data from Japan, including consumer prices, manufacturing, retail sales and employment, could prompt the Bank of Japan to return to zero interest rates and a controversial quantitative easing policy dropped just two years ago. Japan's policy rates currently stand at 0.1 percent.
Barclays estimates that a one percentage point permanent decline in the U.S. cyclically-adjusted fiscal deficit as a share of GDP has been associated with a 9 percent decline of the dollar since the 1970s.
The weaker dollar and pound are leading to a firmer euro, which has appreciated by 10 percent since early December on a trade-weighted basis.
Barclays calculates that a 6 percent appreciation in the euro's TWI is roughly equivalent to a full percentage point rate hike. "The deteriorating growth outlook for the euro zone is likely to force the European Central Bank to ease more than expected," it said.
Many financial markets are closed Thursday for the Christmas day holiday. Japan's markets are closed on Tuesday.
HOW TO FORM BOTTOM
World stocks, measured by MSCI, rose nearly 2.5 percent on the month, on track for the first monthly rise since May.
While many are not rushing to announce that stock markets have convincingly bottomed, those who are waiting for another major sell-off to mark the trough in risky assets and go back in could find themselves too late in the game.
"Everybody is expecting capitulation to mark a bottom markets but the bottom might be marked by people not doing anything," said Clive Beagles, senior fund manager at UK-based boutique fund Jo Hambro Capital Management. Julian Chillingworth, chief investment officer of Rathbones Unit Trust Management, reckons the stage after capitulation is likely to signal the trough.
"The market will bottom at the bleakest point -- (that means) low volume. People are not prepared to deal. They lost a lot of money and are completely cheesed off," he said.
Many say valuations are cheap. Chillingworth notes the FTSE equity dividend yields, currently at 4.81 percent, have surpassed the 10-year benchmark gilt redemption yield, at 3.46 percent, and the gap is the widest in more than 20 years.
"You need to go from capitulation to total disinterest in forming a bottom. Personally I don't think we have hit the bottom. Undoubtedly people are trying to mark the bottom. It may be a little lower."