Dollar languishes at seven-month low after Fed's surprise on tapering

By Anirban Nag

LONDON (Reuters) - The dollar struggled near a seven-month low against a basket of major currencies on Thursday after the Federal Reserve wrong-footed many investors who had positioned for a scaling back in its massive stimulus programme.

The safe-haven yen fell too, sliding to a 3-1/2 year low against the euro, as the Fed's decision sparked a rally in riskier assets and currencies. So widespread was the yen sell-off that it also hit a 23-year low against the Swiss franc, another safe-haven currency.

The dollar index was down 0.15 percent, adding to the previous session's 1.1 percent drop, its biggest one-day slide in more than two months, after the Fed kept the size of its asset-buying programme at $85 billion a month, confounding expectations for a reduction of roughly $10 billion.

It has fallen to levels not seen since well before Fed Chief Ben Bernanke first floated the idea of reducing the stimulus in May.

The dollar index last stood at 80.113, after having fallen to 80.060 on Wednesday, its lowest level since February. It fell as rate-sensitive U.S. Treasury yields, with which the index has a strong correlation, slid to 0.32 percent from a recent two-year high of 0.52 percent.

The dollar's losses saw the euro hit a 7-1/2 month high of $1.3569, with this year's high of $1.3711 the target for some euro bulls, traders said.

"U.S. yields are lower and it makes sense to move out of dollars into the euro and sterling," said Jeremy Stretch, head of currency strategy at CIBC World Markets.

"By the time we have the European Central Bank meeting early next month, we could have the euro at $1.37 which will pose a headache to (President Mario) Draghi."

A stronger currency would hurt exports and is the last thing the ECB would want, given it has pledged to keep monetary policy accommodative for longer to support a nascent economic recovery.

GROWTH CURRENCIES FARE WELL

Citing tightening financial conditions, Fed Chairman Ben Bernanke refused to commit to begin reducing the bond purchases this year. The Fed also cut growth forecasts for 2013 and 2014, citing strains in the economy from tight fiscal policy and higher mortgage rates.

The surprise decision saw U.S. Treasury yields tumble while riskier assets like stocks, staged a rally. Near term implied volatilities also fell, reflecting healthy risk appetite with sharp swings in currencies unlikely.

"Dollar bulls are seen taking a leave of absence until the tapering story reasserts itself," Deutsche Bank analysts said in a note. "In G-10 land, the Fed surprise is likely worth another 2 percent dollar weakness against most pairs, with the notable exception of a more resolute dollar/yen."

Higher-yielding currencies fared well as the tap for cheap dollars remained open. The New Zealand dollar climbed 0.8 percent to a four-month high of $0.8436, getting an added lift after data showed New Zealand's economy grew at a better-than-expected pace in the second quarter.

The rally in riskier assets weighed on the yen. The euro soared to a 3-1/2 year high against the yen of 134.21 while the dollar rose 1 percent to 99.005 yen, pulling away from Wednesday's three-week low of 97.76 yen.

The dollar's moves versus the yen were being influenced by two conflicting factors, the drop in U.S. bond yields on the one hand and a bounce in risk appetite on the other.

"Going forward it looks like the stock markets will dominate over interest rate differentials and this will help cross/yen and dollar/yen," said Ned Rumpeltin, Head of G-10 FX strategy at Standard Chartered Bank.

"We expect Japanese capital outflows to pick up and that should weigh down on the yen. The market will be comfortable with the short-yen positions."

(Editing by Toby Chopra)