* Dollar hits 5-year high vs yen, later retreats
* Markets reassured by Fed message on interest rates
* Australian dollar near 3-1/2-year lows
* Euro just off almost two week low of $1.36495
By Laurence Fletcher
LONDON, Dec 19 (Reuters) - The dollar struggled to gain ground on Thursday after the Federal Reserve surprised many analysts by announcing its long-awaited first cut in bond-buying but couched it by promising interest rates would stay low for longer.
A large majority of market watchers had expected the Fed to wait until next year before starting to reduce its stimulus for the economy but any impact on the dollar - which should in theory gain as a result - was tempered by the fact that much of the move had already been priced in by markets.
The Fed also said it “likely will be appropriate” to keep overnight rates near zero “well past the time” that the U.S. jobless rate falls below 6.5 percent - effectively extending the timeline for beginning to raise base interest rates.
The dollar jumped to a five-year high against the yen of 104.37 yen after the Fed decision before losing ground to trade lower at 103.96 yen. Traders said “short” bets on the yen falling were already stretched near to a maximum and that was also likely to check any dollar gains in the near term.
”The Fed took with one hand and gave with another,“ said Simon Smith, head of research at FxPro. ”They sweetened the pill as much as they could.
“Tapering is not as dollar-positive as it would have been if it had happened in September.” Smith added that while he expected the dollar to strengthen next year, he did not expect it to hang onto these gains in the first quarter as fourth quarter GDP numbers slow compared with the third quarter.
Analysts were united in expecting the Fed’s move, put off in September due to U.S. budget problems, but the central forecast before Wednesday had been for it to begin tapering off bond purchases in March.
The actual reduction in monthly asset purchases was minimal - $10 billion - and they remain at a staggering $75 billion a month in extra dollars that are coursing through global markets.
The dollar has already risen 20 percent against the yen this year as the looming tapering contrasted with expectations the Bank of Japan would further loosen its own monetary policy.
Tapering is seen as positive for the dollar because it would push up Treasury yields and attract yield-seeking investors. But crucially two-year U.S. yields fell back on Wednesday after an initial rise as bond investors took reassurance from the Fed’s message on interest rates.
“We’ve been calling for 104.70, 105 as targets (for dollar/yen), and it took this event to get above 104, which was a bit surprising,” said Bart Wakabayashi, head of forex at State Street Global Markets in Tokyo.
“Institutional investors, asset managers were pretty much positioned for this taper,” he said.
The euro lost ground against the dollar to hit its lowest in almost two weeks of $1.36495 as investors took profits from its recent rally. It later recovered some ground to trade at $1.3686, supported by euro zone banks repaying cheap European Central Bank loans, thus tightening liquidity.
The Australian dollar, already under pressure because of the central bank’s desire to see it weaken, hovered near a 3-1/2-year low in the wake of the Fed’s announcement.
The Aussie fell as far as $0.8820, its lowest since August 2010, and was last at $0.8860.