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Dollar strengthens on FOMC as US rate cut bets ebb

The Fed left interest rates on hold at 5.25 percent on Tuesday, as expected, and acknowledged that financial markets have been volatile and credit conditions have become tighter.

But it reiterated that controlling inflation remains its number one policy concern and said that despite the increase in risks to growth, the economy was still likely to expand at a moderate pace in coming quarters.

Financial markets had gone into the Fed meeting fully discounting a one quarter point rate cut by the end of the year. They have since scaled that back to around a 75 percent probability.

“Those who were looking for an early rate cut resulting from all the subprime problems will be dispapointed,” said Neil MacKinnon, chief economist at ECU Group, a hedge fund.

“The Fed still hasn’t sounded the all-clear on inflation. There’s a reassesment (in the market) that while there may be a rate cut further down the line, it’s not imminent. That’s given the dollar some support.”

At 0755 GMT the dollar index, a measure of the greenback’s value against a basket of six heavily-traded currencies, rose 0.2 percent to 80.61, according to Reuters data. On Monday it slipped below 80.0 to its lowest level in 15 years.

The dollar rose 0.4 percent from late US trade to 119.15 yen, almost two full yen up from a four-month low of 117.19 yen hit earlier in the week.

The euro was flat against the dollar at $1.3745 and up 0.4 percent against the yen to 163.78 yen.

Just a short squeeze?

The Australian dollar rose 0.3 percent to $0.8575 and strengthened to 102.14 yen after the Reserve Bank of Australia raised interest rates a quarter point to 6.5 percent.

That’s the highest cost of borrowing in Australia for 11 years, and maintains the Aussie dollar’s status as one of the highest-yielding currencies in the industrialised world.

The return of risk appetite to financial markets in the wake of the Fed’s statement -- equities are up, government bonds are down, credit and emerging market spreads are tighter -- also supported the carry trade, where investors sell low-yielding currencies for higher-yielding ones.

But MacKinnon at ECU Group noted that market players are still cautious about the possibility of widening fallout from the global credit squeeze that has rattled stocks in recent weeks.

He said the dollar’s post-Fed rebound is understandable, given the market’s large short dollar position. But if the credit concerns return to the fore, further upside may be limited.

“Fundamentally, it is still hard to concoct a positive dollar story and the only things saving the dollar are pre-existing positions, extreme levels, and some covering of shorts,” RBS rates and currency strategists wrote in a note to clients.

“Given the market has tried and made little headway on euro/dollar’s upside, if anything there is scope for mild slippage near-term but dips below $1.37 should be bought.”

The focus now, at least for sterling traders, will turn to the Bank of England’s quarterly Inflation Report at 0930 GMT.

Markets and analysts still expect one more rate hike from the BoE to 6 percent but the outlook beyond is hazy. It will likely remain so with easing inflation and financial market turbulence on the one hand, and risks of rising wage growth and a still booming housing market on the other.