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Monday May 5, 2008 - 20:32:17 GMT
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FOREX NEWS-Dollar stalls as investors debate health of US economy

Mon May 5, 2008 4:26pm EDT

(Updates prices, adds comment, byline)

By Steven C. Johnson

NEW YORK, May 5 (Reuters) - The dollar fell on Monday for the first time in three sessions as oil prices hit a record high, sparking debate about the strength of the U.S. economy.

The U.S. services sector grew in April for the first time in four months, according to a report on Monday. But that news was overshadowed by a Federal Reserve survey showing the banking sector remained in the grips of a credit crunch.

Last week, the dollar rose after a report showed the economy shed 20,000 jobs in April. Though it was the fourth straight monthly decline, employers cut far fewer jobs than market watchers had expected, prompting a bit of cautious optimism.

After trimming interest rates to 2 percent last week, the Federal Reserve hinted it may move to the sidelines and pause its aggressive seven-month easing campaign that has reduced the dollar's appeal to global investors.

But while data shows the U.S. economy continued to eke out modest growth in the first three months of 2008, investors remain wary of declaring a sustained dollar recovery with oil at a fresh record high above $120 a barrel CLc1 and more corporate fallout expected from the credit crunch.

"It is premature to say (the U.S. economy) definitely won't fall into a recession," said Ashraf Laidi, chief currency analyst at CMC Markets in New York. "You must remember, we have seen four consecutive months of declines in payrolls."

In a note to clients on Monday, Scotia Capital senior currency strategist Camilla Sutton warned of "ongoing downside risk to the U.S. economy," adding "the housing market has yet to bottom, consumer confidence is at multi-decade lows, employment growth has evaporated and high commodity prices are only exacerbating an already weak economic backdrop."

Against a basket of six major currencies, the dollar was down 0.3 percent at 73.220 .DXY. The greenback also fell 0.5 percent to 104.80 yen <JPY=> as doubts about the U.S. outlook dulled investor risk appetite. Trading volume was lighter than usual with London and Tokyo closed for public holidays.

The euro rose 0.4 percent to $1.5489 <EUR=>, shrugging off earlier data showing euro zone investor morale had unexpectedly weakened in May.

Investors were far more concerned with the expected trajectory of European Central Bank interest rate policy.

With food and energy costs on the rise, ECB President Jean-Claude Trichet warned again on Monday of "significant" inflation risks, suggesting benchmark rates would likely stay fixed at 4 percent when the central bank meets on Thursday.

Consumer prices in the euro zone rose by 3.3 percent in the 12 months to April, below the prior month's reading but still well above the ECB's target of about 2 percent.

"Trichet has been consistent in telling the market he has but one needle in his compass, and so long as the data continues to suggest inflation pressures, he'll remain hawkish," said Michael Woolfolk, senior currency strategist at The Bank of New York Mellon in New York.

The single currency, though, is still well below its $1.6018 record high set last month, and Woolfolk said Trichet would "probably have to come out and sound the warning bells for a rate hike" before it retests that level.

The dollar briefly pared losses after data on Monday showed the U.S. services sector grew unexpectedly in April, easing some concerns about the economy, but the positive momentum proved fleeting in the currency market. For more, see [ID:nN05377572]

The services sector represents about 80 percent of U.S. economic activity, including businesses such as banks, airlines, hotels and restaurants.

"The question is, 'Will we stay in expansionary territory?," said CMC Markets' Laidi. "We have nearly two months until the next Fed meeting, so a lot could happen."

The Fed next meets on June 24-25 and federal funds futures contracts were on Monday pricing in just a 12 percent chance of another quarter-percentage point rate cut to 1.75 percent.

The Fed began cutting benchmark rates in mid-September, when they stood at 5.25 percent.

Also weighing on the dollar was news that Microsoft Corp (MSFT.O: Quote, Profile, Research) dropped its bid for Yahoo Inc (YHOO.O: Quote, Profile, Research), clouding the mergers and acquisitions outlook. (Additional reporting by Nick Olivari, Editing by Gary Crosse)

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