Dollar rallies after hawkish Fed; pound slides as BoE warns of 'very challenging' outlook

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By Amanda Cooper

LONDON (Reuters) - The dollar strengthened on Thursday, after the Federal Reserve signalled U.S. interest rates will likely peak at a higher rate than markets had expected, while the pound fell after the Bank of England raised rates but warned of a "very challenging outlook."

The BoE lifted UK interest rates to 3% from 2.25% in its largest single increase since 1989 as it battles the twin forces of a slowing economy and red-hot inflation.

The central bank forecasts inflation will hit a 40-year high of around 11% during the current quarter, but it pushed back against expectations for further steep rate hikes, saying Britain has already entered a recession that could potentially last two years - longer than during the 2008-09 financial crisis.

The pound initially slid by as much as 1.7% against the dollar after the BoE's statement and dropped against the euro before recovering some ground.

"The pound has been slipping against the resurgent dollar all morning but notably it has fallen against the euro also following the BoE announcement and the perception that this was a dovish hike," Jane Foley, head of FX strategy at Rabobank, said.

Thursday's decision - the biggest rate rise in 33 years apart from a failed attempt to support the pound on Black Wednesday in 1992 - was in line with economists' expectations in a Reuters poll, but was not unanimous.

"With two members of the MPC not willing to endorse the 75 bps rate hike this month and given the likelihood that the UK economy will be in recession the next time the BoE meets, the prospects of another 75-bps hike from the Bank could appear to be too difficult an ask," Foley said.

The pound, like most major currencies, had already been on the backfoot against the dollar on Thursday.

The Fed on Wednesday raised its benchmark funds rate by 75 basis points to 3.75-4% as widely expected. The dollar initially fell on hints in the Fed's statement of smaller hikes ahead, but rebounded after Chair Jerome Powell said that the battle against inflation will require borrowing costs to rise further.

Powell dashed any expectations that the central bank could soon shift to a less aggressive policy stance, and pushed the dollar to a two-week high against the euro of $0.973.

Two-year U.S. Treasury yields, the most sensitive to shifts in interest-rate expectations, were last up 15 basis points at 4.73%, their highest since July 2007.

"The post-Fed FX price action follows closely the so-called ‘dollar smile' – the framework that postulates that the dollar should be supported whenever the Fed is leading the central bank charge against global inflation or whenever the Fed actions fuel risk aversion," Credit Agricole (OTC:CRARY) head of G10 FX strategy Valentin Marinov said.

The dollar index rose 1.3% on the day to 112.83, its highest since Oct. 21.

The yen eased 0.2% against the dollar to 148.24, as traders continue to watch for any further official intervention to shore up the battered Japanese currency.

Japan spent a record $42.8 billion propping up the yen last month via a series of unannounced purchases, after spending almost $20 billion in September.