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

By Steven C. Johnson

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.