Dollar falls after Fed action ends week of active trading

NEW YORK (Reuters) - The dollar fell broadly on Friday after the Federal Reserve slashed its discount rate on loans to banks and said U.S. economic growth could slow in light of tightening credit markets.

The dollar started to pull back from a seven-week high against a basket of major currencies on Thursday after investors sought safe-haven bids in low-interest currencies and U.S. Treasuries in the midst of a global equities weakness.

The Fed's action, cutting the interest rate charged on direct Fed loans to banks by a half-percentage point to 5.75 percent, followed a month-long slide of more than 1,100 points on the Dow Jones industrial average .DJI and eased credit shortage fears in the equities market.

But the greenback fell as many players speculated on the chances for an interest rate cut by the central bank, which would reduce the dollar's yield advantage against other currencies.

"The Fed's move seems to be an acknowledgment of the disorderly markets," said Tom Benfer, vice president of foreign exchange at Bank of Montreal in New York. "The immediate impact was on equities, and foreign exchanges followed the equities market, moving the euro and Australian dollar up against the dollar."

In late afternoon trades, the euro was 0.5 percent higher at $1.3485, on pace for the biggest gain in a month.

The dollar index .DXY, which tracks the dollar's performance versus a basket of currencies, was down 0.44 percent to 81.371, after reaching a seven-week high early Thursday of 82.132.

Against the yen, the dollar was nearly flat at 114.28 yen while the euro climbed 0.42 percent to 153.99 yen.

The dollar hit its biggest weekly decline since early March against the yen as risk-averse traders vigorously unwound carry trades, in which investors borrow cheaply in low-yielding currencies like the yen to buy higher-yielding assets.

These trading shifts pummeled high-yielding currencies like the New Zealand dollar, which slid 10 percent against the yen, and the Australian dollar, which fell 9.6 percent against the yen in the largest weekly decline since October 1998.

The Reserve Bank of Australia intervened overnight Friday for the first time since 2001 to restore liquidity for the Australian dollar.

The euro was off by almost 5 percent this week against the yen, the biggest weekly loss in four years.

UNWINDING CARRY TRADES BRING MORE VOLATILITY

Japanese retail currency investors trading on margin -- a stalwart force in keeping the yen weak -- halved their bets against the yen this week, JPMorgan analysts said in a note. Their aggregate short position shrank this week to 3.3 trillion yen from 6.9 trillion yen as of Monday.

Sterling was hit hard hit this week, falling almost 3 percent to $1.9814, the largest weekly decline in almost a year, after long holding favorite-status with dealers for its relatively high interest rate.

The Fed's action slowed the unwind of carry trades from its torrid pace on Thursday, but market strategists said high-yielding currencies, particularly in emerging markets, are still at risk.

"The market volatility will remain high despite today's Fed move," said economists with Standard Chartered in New York. "Emerging market currencies will find comfort in today's move, as will carry positions in general. But we do not believe the shakeout in emerging market currencies is over just yet," they said.

Despite the stock market's rapid rise on Friday, which boosted the S&P 500 almost 2.5 percent, some analysts anticipated more rocky trading days ahead.

"(The Fed) has perhaps gained some leeway from the ECB, which has stepped into the breach forcefully, picking up where Greenspan left off," CitiFX strategists said in a research note. "But as the risk of a U.S. recession increases ... the Fed will likely oblige. This might reduce U.S. home bias and reverse the most recent USD strengthening. But it is unlikely to bring back the carry trade in full force." (Additional reporting by Vivianne Rodrigues, Kevin Plumberg and Nick Olivari)