Whenever pension funds, mutual funds and insurance companies decide they should own dollar assets that are out of favor with hedge funds, the hedge funds lose.
Institutional investors bought more dollars than they've sold this year, according to State Street Corp. and Bank of New York Mellon Corp., the largest money managers for institutions. That's significant because speculators such as hedge funds raised bets against the greenback by 36 percent, data from the Commodity Futures Trading Commission in Washington show.
History indicates institutional investors may be on to something. The dollar gained in 71 percent of the quarters over the past decade when they were net buyers, according to Boston- based State Street. They bought more than they sold in all of the quarters when, like now, benchmark interest rates were below inflation and the current account deficit, the broadest measure of trade, exceeded 3 percent of the economy.
"The dollar can do quite well in this slow-growth environment," said Richard Batty, global investment strategist at Standard Life Investments in Edinburgh, a mutual and pension fund that manages the equivalent of $283 billion. "We've had for some time a positive position on the U.S. dollar."
After falling to a 13-year low of 78.993 in March, the dollar has gained 2.5 percent to 80.993, according to a trade- weighted index maintained by the Federal Reserve that includes the euro and yen. It has rallied 3 percent versus the euro to $1.5527 since hitting a record low of $1.6019 on April 22.
Dollar buying among institutional investors from mid-March has been twice as strong as the 12-month average, according to Bank of New York Mellon, which has $23 trillion under custody. That coincides with the Fed's bail-out of Bear Stearns Cos., a move that signaled that the central bank wasn't going to let a securities firm fail and drag down the economy.
"Institutional investors have been gradually building a long-dollar position," said Michael Metcalfe, the London-based head of macro strategy at State Street, which has $14 trillion under custody. "It reflects a belief that the dollar will rebound. Bearish currency speculators will be the next to capitulate."
The currency is forecast to gain 6.6 percent against the euro and 4.6 percent against the pound by the end of March, according to the median estimate of 42 analysts surveyed by Bloomberg.
Pension, mutual fund and insurance companies, which tend to hold their positions longer than speculators, controlled $59.4 trillion in 2006, according to an October 2007 report from the McKinsey Global Institute. Hedge funds and private equity investors had $2.1 trillion under management.
Dollar bears are hanging on to their pessimistic view on speculation faster inflation will keep the economy from rebounding while the trade deficit weighs on the greenback. Plus, the Fed's target rate for overnight loans between banks, at 2 percent, is 1.9 percentage points below the trailing 12-month consumer price index.
"Conditions for a dollar rebound are not yet in place," said Robert Kowit, senior portfolio manager who manages $3 billion of global bonds at Federated Investors Inc. in Pittsburgh. "The dollar is going to drift lower."
The total number of contracts, owned by hedge funds and futures trader, betting on a decline in the dollar against major currencies net of those betting on a gain rose numbered 201,103 on May 27 from 147,887 on Dec. 31, figures from the Commodity Futures Trading Commission show.
Prospects that the Fed may need to raise rates later this year to stem inflation has even some hedge fund bears reconsidering their positions. Futures on the Chicago Board of Trade show a 26 percent chance the Fed will increase its target rate to 2.5 percent by year-end, up from 10 percent a month-ago.
ECU Group Plc of London closed out trades in mid-May betting against the dollar, and debates at the hedge fund about whether to start buying the currency are "intense," said Neil MacKinnon, a former U.K. Treasury official who is now chief economist at the fund, which manages about $1.6 billion.
"The dollar may be getting to an inflection point," MacKinnon said. "Its dangerous to ignore that."
The Fed forecasts the U.S. economy will grow as fast as 2.8 percent next year, up from between 0.3 percent to 1.2 percent this year. The euro zone will slow to 1.5 percent from 1.6 percent this year, and Japan to 1.4 percent from 1.5 percent, according to the median estimate of Bloomberg surveys.
Another reason why bulls like the dollar is exports. The trade deficit shrank to an annual pace of $480.2 billion in the first three months of the year, the smallest since the third quarter of 2002. Trade's contribution to growth jumped to 0.8 percentage point, four times more than previously estimated.
"Right now is not a good time to sell the dollar," said Max Tessier, head of foreign exchange at Caisse de Depot et Placement du Quebec, a pension fund that manages about $155 billion from Montreal. "I've been a dollar bear since the beginning of the year, but we got the move we were looking for."
Tessier said the dollar may end the year at $1.50 per euro and at about 127 versus the yen from $1.5554 and 105.52, respectively, at the end of last week. The risk of further U.S. economic weakness is keeping him from "aggressively buying" the dollar, he said.