FOREX-Dollar drops as market sees possible Fed pause

FOREX-Dollar drops as market sees possible Fed pause
Thu Jun 29, 2006 4:31pm ET13
(Recasts, updates prices, adds comments)

By Kevin Plumberg

NEW YORK, June 29 - The dollar tumbled on Thursday after the Federal Reserve raised interest rates, as expected, but left open the possibility its two-year rate raising campaign could end in August.

The Fed raised overnight rates by a quarter percentage point for the 17th straight time, to 5.25 percent, but said slowing economic growth should help limit inflation. For details see [ID:nN29157785].

"The best we can make of this is the Fed is on hold and the dollar is likely to weaken," said Michael Woolfolk, senior currency strategist with Bank of New York.

The euro reversed small losses after the Fed's policy statement was released, rising 0.8 percent to a session high of $1.2667.

The dollar had its largest single-day decline against the yen in two months, dropping more than 1 percent to 114.86 yen .

The interest rate futures market reflected about a 60 percent chance the Fed will hike rates by a quarter point again in August, sharply down from around 80 percent earlier Thursday.

In a key change to its policy statement, the Fed said slower economic growth "should help to limit inflation pressures over time", dropping a phrase from its previous statement that "further policy firming may yet be needed"

Analysts interpreted this subtle but crucial change in the statement language as a move to free the Fed to either pause and survey the state of the economy, or increase interest rates yet again if inflation creeps higher.

"I think (the Fed) is leaving the door open for a pause in August," said Firas Askari, managing director and head of foreign exchange trading at BMO Capital Markets in Toronto. "I think they need to be more convinced of the inflation data for them to move in August," he said.

DOVES' DAY

The dollar had rallied 2.4 percent against several major currencies in June, largely due to more aggressive language used by Fed officials in speeches to describe their tough stance on inflation.

Expectations for more interest rate hikes by the Fed and other central banks around the world sent global equity markets reeling, and investors pushed the dollar higher in a rush to a currency seen as a safe haven.

But the policy statement on Thursday has brought that to an apparent end.

Against the Swiss franc, the dollar was down 0.6 percent to 1.2378 francs , while sterling jumped 0.4 percent to $1.8257 .

"Overall, a slightly more dovish statement than expected," David Mozina, head of New York foreign exchange strategy with Lehman Brothers, wrote in an email. "Timing of next rate hikes again data-dependant and if Fed sees some weakness they will probably pause," he said.

The market's next focus will likely be the June U.S. payrolls report due Friday next week. Stronger-than-expected jobs growth could shift the market back toward anticipating another rate increase in August.

To that end, Alan Ruskin, chief international strategist with RBS Greenwich Capital, in Greenwich, Connecticut, said investors should be wary of reading too much into the Fed statement.

"There is a very real danger, that if the Fed gives the market what it thinks it wants - an early end to tightening cycle - the credibility issue will rear its head, with greed not the obvious winner over fear, in such circumstances," he said.

"This suggests some obvious restraints to any sustained resurgence in risk appetite." (Additional reporting by Steven C. Johnson and Gertrude Chavez-Dreyfuss)