FOREX-Dollar subdued as markets position for modest Fed taper
* Dollar index hovers near four-week trough
* Fed likely to reduce stimulus modestly, sound dovish
* Currencies trade in tight ranges before Fed
By Anooja Debnath
LONDON, Sept 18 (Reuters) - The U.S. dollar traded near a four-week trough against a basket of major currencies on Wednesday on prospects that any move by the Federal Reserve to trim its stimulus will be modest.
The Fed's highly anticipated rate review ends later in the day and markets expect the central bank will probably announce a slight reduction to its $85 billion monthly bond-buying programme while stressing that interest rates will stay low for a while.
Indeed, since a disappointing U.S. non-farm payrolls report on Sept. 6, markets have scaled back expectations on the size of any pullback in stimulus.
Traders said currencies would stay in tight ranges as investors were unwilling to take fresh positions before the outcome of the Fed's policy review due at 1800 GMT. Chairman Ben Bernanke will give a news conference a half hour after that.
The dollar index was down 0.1 percent at 81.095, close to Monday's four-week low of 80.968.
"We expect the Fed to taper by $10 billion and some in the market are pushing for $15 billion. I think they are also going to try and push the message that rates aren't going to go up anytime soon," said Paul Bednarczyk, head of research at 4CAST.
He added that if the amount were less than $15 billion, then the dollar could be dragged lower.
Some analysts said there was a chance the Fed might pledge to keep rates low until the jobless rate falls to around 6.0 percent, revising their previous threshold of 6.5 percent.
Benchmark U.S. 10-year Treasury yields were also lower at around 2.85 percent, below the 3.007 percent touched on Sept. 6, which was a more than two-year high.
The dollar was down 0.2 percent at 98.93 yen. A reported large options expiry at 99.00 yen could keep the pair close to that level.
The euro held steady at about $1.3354, hovering near a 2-1/2 week peak of $1.3385 reached on Monday.
In the options market, near-term implied volatility rose ahead of the Fed meeting. Demand to hedge against excessive price moves tends to rise during market uncertainty.
Overnight euro/dollar implied volatility spiked to a one-and-a-half month high of around 14.50, from around 5.15 on Sept. 17.
Traders said any delay to the tapering may be seen as dovish by markets and could prompt investors to sell the dollar. Conversely a bigger reduction of stimulus could be seen as hawkish, lifting demand for the greenback.
Analysts at Morgan Stanley expect the euro to rise against the dollar in the near-term, adding a move above the Sept. 16 high of $1.3385 could open the way towards $1.3455 initially and then the $1.3600 area.
But they warned of the risks ahead for the single currency.
"We continue to highlight the risk factors for the euro on the horizon, including the German elections on Sunday, where the outcome is becoming increasingly difficult to call."
Chancellor Angela Merkel is widely expected to win the election but a poll on Wednesday showed her centre-right coalition could fall short of a majority.
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