LONDON, Jan 29 - The dollar handed back some of its earlier gains against the euro on Thursday after rallying to a one-week high in the wake of a signal from the U.S. Federal Reserve seen as a step toward higher interest rates. The Fed left rates steady on Wednesday but surprised many in the timing of its decision to drop its pledge to keep rates low for a "considerable period", instead saying it "can be patient" about lifting its key interest rates. U.S. equities and bonds dived, but the move proved a much-wanted boost for the dollar which has been dogged by the outlook for continued low interest rates.
"The change in the Fed's language brings forward rate hike expectations. It's positive for the dollar because it reduces rate differentials between the U.S. and other countries and it brings in flows," said Mark McFarland, currency strategist at UBS. "But this was pretty much a bear market rally. The U.S. current account is not fully funded and it takes a substantial rise in the U.S. rates or export growth for the dollar to turn around." By 1030 GMT, the dollar stood at $1.2500 after rising to a one-week high of $1.2416 earlier in Asia. Against the yen it stood at 106.00 , off this week's three-year low around 105.45.
G7 CONSIDERABLE FOCUS
The Fed held the federal funds rate target at one percent, its lowest since 1958, but the statement it issued on Wednesday left investors with a sense it was preparing the ground for eventual rate rises, however vague the timing of any action might be. The dollar's rally also gave relief for euro zone officials, who have expressed concerns about a rapid rise in the euro ahead of a Group of Seven finance ministers meeting next week. "The Fed did remove the phrase 'considerable period' but it maintained almost the equal bias and the overall assessment of the economy has not actually changed. They are more cautious on the labour market. All they wanted to do is to get out of the trap on 'considerable period'," said Niels Christensen, currency strategist at Societe Generale. "Also playing into the equation is the upcoming G7 meeting. The move down in the euro/dollar reduces concerns among euro zone officials about the stronger euro and they will be less inclined to push hard to curb euro strength at the G7." Markets are particularly keen to hear what the European Central Bank president Jean-Claude Trichet will have to say when he speaks in Madrid at 1300 GMT.
Trichet has said the ECB dislikes excessive volatility and too fast changes in exchange rates. "The G7 meeting is still the biggest issue, but the Fed statement seems to suggest the United States is not totally unconcerned about inflation or a sharp drop in the dollar," said Toru Umemoto, currency strategist at Morgan Stanley in Tokyo. For Japan, it was business as usual. Vice Finance Minister Masakazu Hayashi said Japan was not aiming to target specific currency levels but warned recent movements were rapid and Japan would take action. Japan's top financial diplomat Zembei Mizoguchi said that stable currency markets over the medium term were desirable and that the authorities were closely monitoring the market.
Fed chairman Alan Greenspan and U.S. Treasury Secretary John Snow are also speaking at 1530 GMT in Washington. U.S. jobless claims, due at 1330 GMT, will be closely watched for clues on the state of the labour market. Minutes from the December Fed meeting are also due.//