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How the smart money is set up for a rate hike

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With the financial community abuzz over a looming interest rate hike by the Federal Reserve, the smart money is betting big on the U.S. dollar instead of Treasurys.

Instead of betting on the price of, say, 10-year U.S. government bonds, prominent hedge fund firms—including Bridgewater Associates, Brevan Howard, Tudor Investment and Moore Capital Management—have serious money on a related currency trade.

They are betting "long" that the U.S. dollar will continue to gain in value as the Fed tightens its monetary policy with a rate hike. At the same time, the funds are wagering "short" that countries in the euro zone, Japan and elsewhere will dilute the value of their currencies with fresh rounds of stimulus and low interest rates.

"The focus is really on what a rate hike means for currency movements," said Eric Siegel, global head of hedge funds at Citi Private Bank.

The most popular trade is to be long the dollar and short the euro.

The consensus view is that the U.S. economy is relatively strong, giving Janet Yellen's Fed the confidence to ease off of ultralow interest rates in place since the aftermath of the financial crisis in 2008. At the same time, Europe is seen as more fragile, and central bankers there have pledged to keep interest rates low by buying 60 billion euros of bonds a month.

Read More ECB begins bond-buying: What should you do?

"While the United States is showing strong signs of growth and is engaging in a trend of gradual tightening by the Fed, weak growth and heightened deflationary risks in Europe and Asia are being fought with increased monetary expansion," Gávea Investimentos wrote in a private letter to clients of macroeconomic-focused hedge fund in March.

Gávea is the $6 billion Brazil-based alternative asset management unit of JPMorgan Chase and is led by former Braziian central bank president Arminio Fraga Neto and Luiz Henrique Fraga. A spokesman at JPMorgan declined to comment.

The Gávea "macro" fund letter noted that currency bets were its largest of all asset classes; the wagers include long positions in the dollar and shorts on the euro and other currencies. Such bets have pushed the main Gávea Fund up an estimated 6.8 percent net of fees this year through March 20, according to performance information obtained by CNBC.com.

Other prominent hedge fund firms who currently have the long dollar versus short euro bet on include Ray Dalio's Bridgewater Associates, Alan Howard's Brevan Howard, Leda Braga's Systematica Investments, Paul Tudor Jones' Tudor Investment, Louis Bacon's Moore Capital Management and Andrew Law's Caxton Associates, according to people familiar with their positioning.

Representatives for those firms declined to comment or did not respond to a request.

Select hedge fund performance this year

Fund 2015 Perf (net) Date
BlueTrend (Systematica)11.50%3/13/2015
Bridgewater Pure Alpha II11.20%2/28/2015
Gavea Fund (JPMorgan)6.80%3/20/2015
Caxton Global Investment6.80%3/10/2015
Moore Global Investments6.80%3/12/2015
Tudor BVI Global4.70%3/6/2015
Brevan Howard Fund3.60%3/6/2015

Source: Source: CNBC.com reporting, HSBC Alternative Investment Group report

Betting on the dollar has already been a winning trade. The currency has appreciated more than 27 percent versus the euro over the past year; it's up more than 17 percent versus the yen.

"Managers still see more movement for the dollar," Siegel said of the currency gaining versus the euro and yen, according to hedge fund positioning before Yellen's March 18 policy statement.

That view was backed up by currency strategists at UBS in a recent note. The analysis recommended longs on the dollar and shorts on the euro, yen and emerging market currencies.

Read MoreDollar falls on more unwinding of bullish bets after Fed

All eyes on the Fed
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All eyes on the Fed

Currency bets aren't risk free, especially when they are juiced by borrowed money.

Macro hedge fund Everest Capital, for example, recently lost more than 80 percent of its $3 billion in assets under management when a likely bet using leveraged debt on the Swiss franc backfired, causing steep losses in one fund and clients of others to pull their money.

The dollar, euro or yen aren't likely to move 30 percent in a day like the franc did in that instance, but there could still be trouble, especially if interest rates don't increase as expected this year.

"The bigger pain trade may be in FX and could suffer badly if the Fed doesn't hike," said Norman Kilarjian, head of relative value and tactical trading research at investment consultant Aksia.

Read More Hedge fund Everest Capital falls off a Swiss cliff

Despite the focus on currencies, funds still have some bets on Treasurys.

Funds have majority long bets on two-year and 30-year U.S. Treasurys, according to a March 22 report by Bank of America Merrill Lynch. The report also noted that short bets on 10-year U.S. Treasurys had fallen to near-neutral levels (an even balance of longs and shorts on the bonds).

No T-Bill theme

Still, betting on Treasurys isn't a major theme for funds, according to Siegel.

"I don't think anybody's getting too worked up about a 25 basis point rate hike," Siegel said, referencing the likely small-size of any increase (25 basis points equals 0.25 percentage points).

The prospect of interest rates rising has been discussed for several years, making any move relatively predictable.

"There's no easy trade to take advantage of the Fed hiking in June or September," said Chris Solarz, a managing director at investment consultant Cliffwater who focuses on macro funds.

"It's not going to be a surprise. It's pretty well telegraphed," Solarz added. "As someone put it to me, it's going to be the Y2K moment of 2015."

Experts also note that bond-focused hedge funds—or "credit" managers—usually try to avoid the risks of interest rate fluctuations using hedges such as future contracts on the value of Treasury notes. That frees them to focus on the dynamics of specific country or company bonds, especially those in distress and a larger potential gain in value.

"They generally don't look to take a view on rates. It's not specific to the current environment, it's how they almost always run their books," Siegel said.

Some caution

While many managers are relatively positive on the U.S. ahead of a rate hike, at least one prominent investor is taking a more cautious view.

"We don't know—nor does the Fed know—exactly how much tightening will knock over the apple cart," Dalio and Mark Dinner of $169 billion Bridgewater wrote in a private note to clients and other followers recently. "What we do hope the Fed knows, which we don't know, is how exactly it will fix things if it knocks it over. We hope that they know that before they make a move that could knock over the apple cart."

The two wrote that they expect a Fed move on interest rates in June or September, the market consensus, and as a result are "cautious" about portfolio exposure and are avoiding concentrated bets.

Read MoreDalio: We're 'cautious' ahead of Fed move