Dollar rallies as Fed signals more rate hikes; pound drops

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By Amanda Cooper

LONDON (Reuters) - The dollar rose on Thursday, buoyed by a sharp rise in Treasury yields, after the Federal Reserve signaled U.S. interest rates will likely peak above where investors currently expect, while the pound fell ahead of a Bank of England policy meeting.

The Fed on Wednesday raised its benchmark funds rate by 75 basis points (bps) 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.

"Incoming data since our last meeting suggests that the ultimate level of interest rates will be higher than previously expected," Powell told reporters, adding: "It is very premature to be thinking about pausing... we have a ways to go."

Powell's hawkish comments 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 $0.9810.

Two-year U.S. Treasury yields, the most sensitive to shifts in interest-rate expectations, were last up 11 basis points at 4.68%, their highest since July 2007.

“In terms of the reaction to the Fed meeting, it was more on the hawkish side and in particular, the comment that the terminal rate that markets are pricing in around 5% could be higher than that. That was clearly that was a boost to both dollar and the US yield appeal," Credit Agricole (OTC:CRARY) head of G10 FX strategy Valentin Marinov.

The dollar index rose 0.5% on the day to 112.70, its highest in a week.

"Really this is about the ‘dollar smile' whereby the dollar is supported whenever the Fed is leading the charge against inflation -- it is one of the most, if not the most, hawkish central bank out there. And equally, the dollar is also supported when Fed actions fuel risk aversion. And again today, the reaction is an example of how those two forces work in tandem,” Marinov said.

Meanwhile, the pound dropped 0.5% against the dollar to $1.13325, but eased by just 0.1% against the euro to 86.22 pence ahead of the Bank of England meeting, at which the central bank is expected to raise interest rates by three quarters of a percentage point to 3%, its biggest rate rise since 1989.

The BoE is not in the same boat as the Fed, given the slowdown in the economy and the dramatic rise in UK government borrowing costs since the summer, strategists said.

"We expect the BoE to signal that a larger hike today is unlikely to be the first of a series of larger hikes and that market expectations for further hikes are likely still too aggressive," MUFG strategist Lee Hardman said.

"It should encourage a weaker pound and reinforce the move

lower in cable from overnight," he added.

The Japanese yen eased 0.2% against the dollar to 148.18, as traders continue to watch for any further official intervention to shore up the battered 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.