Dollar falls, bond prices gain as focus on U.S. economy, Fed

By Caroline Valetkevitch

NEW YORK (Reuters) - The dollar fell and Treasuries prices rose on Thursday as relief over a U.S. budget deal shifted to focus on the effect of the 16-day government shutdown on the economy and prospects of a re-run early next year.

Analysts said economic weakness resulting from the shutdown and uncertainty over the next round of budget and debt negotiations may keep the Federal Reserve from withdrawing monetary stimulus at least until a few months into the year.

U.S. stocks were mixed, with disappointing results from International Business Machines dragging down the Dow. IBM shares hit a two-year low a day after it reported a 4 percent drop in third-quarter revenue, weaker than expected. The shares were down 6.7 percent at $174.15.

President Barack Obama overnight signed legislation to fund the government until January 15 and extend a debt ceiling deadline to February 7, pulling the world's biggest economy back from the brink of a historic default. The move did little, however, to resolve the underlying disputes that led to the crisis in the first place.

The temporary nature of the agreement and longer-term worries that the debt ceiling risks would become a structural drag on the economy left significant unease for investors.

"The impact of the government shutdown and the possible fogginess of the economic data we'll get for a while has convinced more large firms that the Federal Reserve will not reduce its bond purchases until next year," said Matthew Duch, portfolio manager at Calvert Investments in Bethesda, Maryland. "It becomes harder for the Fed to remove itself from the market."

The dollar fell against the euro to its lowest in more than eight months. The euro rose as high as $1.3681, the highest since early February and was last at $1.3667, up 1.0 percent on the day and its largest percentage gain in a month.

The dollar index was down 0.8 percent at 79.696 after earlier falling to 79.613, its lowest since February 7.

"We would expect this impasse to shave off part of fourth-quarter growth and hurt consumer confidence, especially from the government sector," said Simon Derrick, head of currency strategy at BNY Mellon in London.

The expectations over the Fed boosted Treasury prices, along with the fact that the debt deal encouraged investors to reinvest cash.

Benchmark 10-year notes rose 24/32 in price, their yields easing to 2.58 percent from 2.67 percent on Wednesday, when yields had eased in anticipation of a debt ceiling deal. Yields have dropped from 3.0 percent before the Fed decided last month not to pare its bond purchases.

Also, interest rates on ultra-short-term U.S. government debt fell sharply. The government had been expected to exhaust its $16.7 trillion statutory borrowing limit on Thursday, raising the risk it would not meet benefit payments and debt obligations in coming days.

Fears that the Treasury Department might delay paying debt holders made some large money market funds shed holdings of Treasury bills that mature in the second half of October into the first half of November, seen most vulnerable if the government could not increase its borrowing capacity in time.

The unease in holding these T-bills had catapulted their interest rates to levels not seen in five years. The one-month yields were briefly double the yields on two-year Treasury notes.

On Thursday, with prompt payment on short-term debt now assured, rates on October U.S. Treasury bills due November 14 last traded at 0.0175 percent, down 13 basis points from late Wednesday, according to Reuters data.

On Wall Street, the Dow Jones industrial average was down 49.83 points, or 0.32 percent, at 15,324.00. The Standard & Poor's 500 Index was up 5.37 points, or 0.31 percent, at 1,726.91. The Nasdaq Composite Index was up 9.73 points, or 0.25 percent, at 3,849.16.

MSCI's world equity index, tracking shares in 45 countries, touched a five-year high and was last up 0.8 percent. European shares ended 0.2 percent higher.

FED'S NEXT MOVE IN FOCUS

The likelihood that the fiscal saga would delay the start of the Fed's planned withdrawal of its monetary stimulus was strengthened by Dallas Fed President Richard Fisher.

In remarks prepared for delivery to the Economic Club of New York, he said: "Kicking the can down the road for a few months will not solve the pathology of fiscal misfeasance that undermines our economy and threatens our future.

Markets had expected the Fed to announce in September that it would cut its bond purchases. When that did not happen, forecasts switched to December, and now many anticipate no action until next year.

By pushing back expectations of Fed tapering, the deal encouraged traders to sell the dollar against the currencies of nations perceived to have less-accommodative policies.

The weaker dollar and the likelihood of Fed holding back on reducing monetary stimulus also gave gold a big lift.

Spot gold rallied to a high of $1,322.56 per ounce early in the U.S. session, up more than 3 percent on the day.

U.S. oil prices slid more than $2 to their lowest since early July as stocks in the Cushing, Oklahoma, oil hub began to reverse a months-long decline. U.S. crude oil was down $2 at $100.29 a barrel.

Brent crude was down $1.48 cents at $109.11.

(Additional reporting by Nick Olivari, Ellen Freilich, Gertrude Chavez-Dreyfuss and Richard Leong in New York, Richard Hubbard in London; Editing by Dan Grebler and Nick Zieminski)