Surprise rate cut sparks dollar sell-off

NEW YORK (Reuters) - The dollar tumbled against major currencies except the yen on Tuesday after the Federal Reserve unexpectedly slashed its benchmark overnight lending rate in an attempt to allay market fears of a U.S. recession.

The Fed's emergency move to cut rates by three quarters of a percentage point was precipitated by a global equities rout.

The U.S. central bank's move wiped out the dollar's yield advantage over the euro, with the federal funds rate target now at 3.5 percent and official euro zone interest rates at 4 percent. This put the European currency on track to post its biggest one-day gain against the dollar in two years.

The cut, which preceded next week's Federal Open Market Committee monetary policy meeting, was not enough to prevent U.S. stocks from falling when the market reopened after Monday's public holiday.

"We are skeptical that the rate decision will have a lasting impact in offsetting concerns over economic slowdown," Tom Fitzpatrick, global head of foreign exchange at Citigroup in New York, said in a note to clients. "Lower interest rates do little to address underlying weakness in the U.S. housing sector and broader economy."

In New York late afternoon trade, the euro was up 1.2 percent on the day at $1.4613 after briefly racing to $1.4643. The euro has rebounded from a one-month low against the dollar of around $1.4366, according to Reuters data.

"Under any other Fed this would not be a surprise, but this Fed has been reluctant to cater to market expectations," said Mark Meadows, currency strategist at Tempus Consulting in Washington. "This should support the euro in the short term, however our long-standing view is still that the U.S. economy will rebound and help the dollar gain into the middle of this year."

Tuesday's emergency step was the biggest Fed rate cut since 1984 and was the first intermeeting cut since September 17, 2001.

Analysts said the bold cut had not changed market projections for the dollar's recovery versus the euro in the second half of the year.

"The aggressive stance by the Fed together with some stimulus package from the government could potentially insure that the economy bottoms around the middle of the year," said Matthew Strauss, senior currency strategist at RBC Capital Markets in Toronto.

"The moment we see that happening we could see a strong and sustained rally in the U.S. dollar."

President George W. Bush has proposed a $145 billion short-term stimulus package to minimize the impact of an economic slowdown.

Against the Swiss franc, the dollar was down 1.1 percent at 1.0963 francs, while the pound rose 1 percent to $1.9615.

The greenback was thumped against the high-yielding Australian and New Zealand dollars. It last traded down 1 percent at US$0.8702 and dived 2.9 percent to US$0.7660.

The dollar, however, fared better against the yen, with analysts citing repatriation flows on the back of collapsing equity prices as well as an improvement in risk appetite after the Fed's rate cut.

It traded up 0.6 percent at 106.62 yen, after earlier touching its lowest in more than two and a half years against the Japanese currency.

Short-term interest rate futures were pricing in a quarter-point rate cut at the January 29-30 meeting and showed a roughly 80 percent perceived chance of a 50 basis points cut. The Fed has been cutting rates since mid-September.

(Additional reporting by Lucia Mutikani and Nick Olivari; Editing by James Dalgleish)