Dollar is down, but not out, as Fed cuts rates

NEW YORK (Reuters) - The Federal Reserve's biggest emergency interest rate cut in more than two decades took a bite out of the U.S. dollar on Tuesday, but could end up helping both the currency and the U.S. economy rebound as early as this spring.

The U.S. dollar fell more than 1.0 percent against the euro, the biggest daily decline in at least a year, after the Fed sought to soothe fears of a recession by cutting its benchmark lending rate by 75 basis points to 3.5 percent.

The Fed's move pushed U.S. short term interest rates below the euro-zone's for the first time in more than three years, leaving investors with less incentive to buy U.S. debt over European.

But money managers believe that weakness in the U.S. economy will soon be felt in Europe and Asia, forcing global central banks to follow the Fed with interest rate cuts of their own.

Alan Wilde, who helps manage a $15 billion portfolio of fixed-income securities at Baring Asset Management in London, said the Fed now appears ahead of the curve and predicts that the European Central Bank will have to follow suit with a rate cut of its own, likely before the end of the second quarter.

"It seems we're back where we were in the early 2000s when the Fed was seen as proactive and fostering growth while other central banks were blinded to the need for policy easing and pursued tight policy that backfired and hurt long-term growth prospects," he said.

Wilde said his firm has started reducing its existing bets against the dollar, and will likely change those trades to anticipate strength in the greenback in the months ahead, an opportunity that he said would become even more attractive should the euro hit a new record high of $1.50.

Paresh Upadhyaya, a portfolio manager at Putnam Investments in Boston who oversees 30 billion in investments, has a similar view.

"Now that markets have digested a gloomier global growth scenario with the U.S. in recession, I think market sentiment as shifted so that countries that are implementing pro-growth policies are going to be rewarded with a stronger currency," he said. "You see that with the dollar recently."

CARRYING THE DOLLAR

However, investors are expecting more rate cuts at the Fed's regularly scheduled policy meeting on January 30, which could weigh on the dollar in the short run.

Some analysts say that could make the dollar a funding currency for carry trades, since the Fed's cut makes the dollar the third lowest-yielding currency in the developed world.

In recent years, investors have used cheaply-borrowed Japanese yen and Swiss francs to fund carry trades that invested in currencies such as the New Zealand or Australian dollars which boast yields of 8.25 percent and 6.75 percent respectively.

"The last thing the U.S. dollar needs is to be cast as a funding currency but that prospect is upon us," said Alan Ruskin, chief international strategist at RBS Greenwich Capital.

Even if other central banks are forced to cut interest rates, Ruskin said U.S. rates are likely to remain lower than those in all major economies except Japan.

ECB IN THE CROSSHAIRS

So far, the ECB has held its benchmark interest rate at 4.0 percent, and President Jean-Claude Trichet has repeatedly said that inflation remains too high to justify easier eurozone monetary policy.

Markets of late have also embraced the idea of "decoupling" in which the rise of developing economies in China, India and Brazil have reduced the global economy's dependence on the U.S. business cycle.

But recent market volatility has put that idea to the test, and a plunge in European and Asian stockmarkts on Monday, while U.S. markets were on holiday, has cast doubt far and wide.

Futures markets are now pricing in an ECB rate cut around midyear, with Baring's Wilde expecting one by spring.

"There could be increased frustration with the ECB if they keep rates on hold longer," said Putnam's Upadhyaya. "That could leave the euro vulnerable to the downside, especially if growth numbers start to turn and they really have already."

The Bank of England is also seen cutting rates next month, while the Bank of Canada reduced lending rates to 4.0 percent on Tuesday and warned that more easing may be necessary.

Meanwhile, Japan's 0.5 percent benchmark rate is unlikely to rise amid such global market volatility.

In the last 24 hours, the dollar was the most bought currency, particularly against the euro, which was sold by hedge funds and large institutional investors, Citigroup said.

In the long run, a global economy that struggles should continue to be dollar-positive, as uncertainty prompts investors to favor defensive assets such as U.S. Treasuries and large capitalization stocks at the expense of riskier emerging market assets and commodities.

"Volatility always signals a change in leadership of financial markets," Merrill Lynch chief investment strategist Richard Bernstein said on Tuesday at a Dow Jones Indexes/STOXX briefing in New York.

(Additional reporting by Nick Olivari and Kevin Plumberg; Editing by Clive McKeef)