Dollar dives, propping up oil; stocks erase losses

By Lewis Krauskopf

NEW YORK (Reuters) - The U.S. dollar tumbled on Wednesday after comments from a Federal Reserve official and a soft services sector report suggested a slowing pace of rate hikes, sparking a rally in oil prices that also boosted U.S. equities.

U.S. crude settled up 8 percent as the weakness in the dollar helped oil and other commodities priced in the currency. U.S. Treasury yields fell to one-year lows before recovering.

The U.S. S&P 500 index erased earlier losses, led higher by the energy and materials sectors.

"What (markets) are keying off of is the move in commodities and in the dollar," said Walter Todd, chief investment officer at Greenwood Capital Associates in Greenwood, South Carolina. "That is driving the rotation in the equity market out of momentum names into commodity-based names."

The Dow Jones industrial average rose 225.44 points, or 1.4 percent, to 16,378.98, the S&P 500 gained 14.56 points, or 0.77 percent, to 1,917.59 and the Nasdaq Composite added 4.02 points, or 0.09 percent, to 4,520.96.

Activity in the vast U.S. services sector slowed to a near two-year low in January, suggesting that economic growth weakened further at the start of the first quarter even as the labour market remains resilient.

The pan-European FTSEurofirst 300 index fell 1.6 percent amid disappointing earnings from Finnish state-controlled utility Fortum and Dutch telecoms group KPN .

MSCI's 46-country All World share index edged up 0.2 percent.

Equities have been tightly correlated with oil in recent weeks as the commodity's 1-1/2-year slide has deepened, with investors worried oil's slide is a sign of shakiness in the global economy.

Oil rose Wednesday after investors took advantage of a drop in the U.S. dollar and earlier weakness in the crude price, despite weekly data showing a surprisingly large rise in U.S. inventory. Russia also repeated its willingness to take part in talks with OPEC producers to cut output.

U.S. crude settled up 8 percent at $32.28 a barrel, while benchmark Brent crude settled up 7.1 percent to $35.04 a barrel.

"We're getting the rally in crude oil from the pounding that the dollar is taking," said Robert Yawger, senior vice president of energy futures at Mizuho Securities USA.

Financial conditions have tightened considerably in the weeks since the Fed raised interest rates and monetary policymakers will have to take that into consideration should that phenomenon persist, William Dudley, president of the Federal Reserve Bank of New York, told MNI in an interview.

Dudley's comments, combined with the ISM data, raised skepticism about the Fed's ability to further raise rates, weighing on the dollar.

According to CME FedWatch, the probability of a Fed rate hike by December is now down to 39 percent.

"Fed rate forecasts are coming under fire," said Joe Manimbo, senior market analyst at Western Union Business Solutions in Washington, in reference to Fed policymakers' December forecast of four rate hikes this year.

The greenback fell 1.6 percent against a basket of currencies and touched a three-month low. The euro gained 1.6 percent against the dollar and hit its highest level since October.

Benchmark 10-year note yields were last down 2/32 in price to yield 1.8705 percent. At one point, yields fell below technical resistance to a low of 1.7930 percent, the lowest since February 5, 2015.

(Additional reporting by Karen Brettell, Devika Krishna Kumar and Sam Forgione in New York, Nigel Stephenson and Sudip Kar-Gupta in London; Editing by Mark Heinrich and Nick Zieminski)