Traders rush to emerging markets currencies

NEW YORK (Reuters) - The dust had barely settled in the currency markets after the Federal Reserve's emergency interest rate cut on Tuesday when dealers went searching for one thing: yield.

Foreign exchange traders initially rushed to emerging markets currencies and sold the U.S. dollar after the Federal Reserve unexpectedly cut its federal funds rate by the most since 1984.

The move may be short-lived though, traders said. Another rate cut by the Fed at a meeting next week, may spark some dollar buying.

Actively traded emerging markets currencies such as Brazil's real, the Turkish lira, and the Mexican peso soared right after the central bank slashed the fed funds target rate by 75 basis points in an attempt to avert a recession in the world's largest economy.

The move comes amid a massive global sell-off brought on by deepening fears that a U.S. recession would drag the rest of the world economy down with it.

Traders said until the impact of the interest rate reduction and a tax cut plan proposed by the Bush administration are felt in the economy, returns for investors may be higher outside U.S. assets.

"Nobody knows how deep this recession is really going to be," said John Taylor, chief executive officer at FX Concepts Inc. in New York, which manages about $15 billion in currencies.

"Cleary the Fed and the government are determined to fight this aggressively, but for now, for most investors it may be safer to be out of the dollar."

Demand for non-dollar combinations, or "crosses", such as Euro/yen, Swiss francs/yen and Australian dollar/yen also rose, traders said, as investors avoided placing bets on the U.S dollar amid uncertainty over the outlook for the economy.

Taylor said he now favors crosses involving the Japanese yen and holds assets in Brazilian reais and Turkish liras. He is short U.S. dollars.

The Fed's emergency move sparked a sell off in U.S. stocks and has wiped out the dollar's yield advantage over the euro.

The fed funds rate target is now 3.5 percent. The last time there was a cut in the federal funds rate of at least three-quarters of a point was in October 1984, though the Fed cut the discount rate by 1.0 percent in 1991.

In contrast, Brazil's real, rallied 1.5 percent and last traded at 1.8063 to the U.S. dollar. The Turkish lira advanced 1.7 percent and traded at 1.1995 to the U.S. dollar.

So-called crosses, like euro/yen were 1.8 percent higher at 155.68 and Australian dollar/yen gained 1.82 percent to 92.85. The New Zealand/yen soared, gaining more than 3.2 percent and trading at 81.43.

Investors frequently borrow in Japanese yen and other low-yielding currencies to fund purchases in higher-yielding assets, in so-called carry trades. That strategy has come under pressure ever since the U.S. subprime mortgage crisis spread to other markets and restricted lending in credit markets.

"We are seeing a massive exit to the crosses and the yen carry trade in full swing," said Brian Taylor, head currency trader at M&T Bank in Buffalo, New York. "Nobody really knows what to do in regards to the dollar right now, so the first reaction is to sell the buck and rush to other places."

Taylor at FX Concepts said it is still soon to rule out another rate cut by the Fed when policymakers meet next week and that some of the currencies benefiting now are unstable in the long term.

U.S. interest rate futures show the odds for a 50 basis points cut by the Fed next week still stand at 80 percent.

"At a certain point you have to ask yourself how much money do you want to put in Turkey," he said. "I wouldn't be surprised to see the dollar rebounding a month or two from now once all this drama, all the volatility fades."

(Editing by Clive McKeef)