The Economist sees signs pointing to a weaker dollar in the coming year:
The greenback’s sinking feeling, The Economist: For ... many Wall Street number-crunchers, the dollar supplied one of the nastiest surprises of 2005. ... Although America’s current-account deficit headed towards $800 billion in 2005, the dollar rose. It was up by 3.5% against a broad trade-weighted basket of currencies, the first rise in four years (see chart). Against the euro and yen, the greenback did even better. It ended the year at $1.18 per euro, up by 14%. Despite a wobble in December, the dollar made a similar advance against the yen.
Not surprisingly, the pundits are more cautious about 2006. Although most expect the dollar to end this year weaker than it began it, the typical forecast is that any decline will be fairly modest and take place mainly in the latter part of 2006. That is because most analysts attribute the dollar’s recent strength to widening differences between American, European and Japanese interest rates. These gaps are expected to grow for a few more months before closing slightly later in the year. ...
Oil exporters may prove more fickle dollar buyers than many expect. In 2005, as oil prices shot up, exporting countries saw their external surpluses soar. A good slice of these petro surpluses found their way into dollar-denominated assets. That led some analysts to conclude that oil exporters were a safe and lasting source of dollar support. An alternative view is that the exporters, like others, were attracted by rising American interest rates. ... China is yet another cause of uncertainty. ... This year ... the Chinese [may allow]... a bigger move in the yuan than markets expect. This week China introduced a system of market making in spot yuan trading that could permit faster appreciation. But the biggest shadow remains America’s huge and rising current-account deficit. Reducing this will, at some point, require a much cheaper dollar. ... The result could be a sharp drop for the dollar.
Here's more from the Financial Times on how China's announcement that it may begin diversifying its foreign exchange reserves to reduce the share of dollars in its portfolio might affect exchange rates:
China signals reserves switch away from dollar, by Geoff Dyer and Andrew Balls, Financial Times: China indicated on Thursday it could begin to diversify its rapidly growing foreign exchange reserves away from the US dollar and government bonds – a potential shift with significant implications for global financial and commodity markets. Economists estimate that more that 70 per cent of the reserves are invested in US dollar assets, which has helped to sustain the recent large US deficits. If China were to stop acquiring such a large proportion of dollars with its reserves ... it could put heavy downward pressure on the greenback. ... although the language was “vague”, Thursday's statement was the first time Safe has publicly indicated a shift away from dollar assets. ...
[Update: Brad Setser has more.]