By Amanda Cooper and Tom Westbrook
LONDON/SINGAPORE (Reuters) -The dollar held firm on Tuesday ahead of an expected interest rate cut in the United States, as traders grow increasingly convinced the Federal Reserve will lower borrowing rates only gradually next year.
The euro, which is heading for a drop of nearly 5% against the dollar this year, traded at $1.04823 ahead of the Fed decision.
The gap between U.S. and German 10-year yields is 216 basis points, near its widest in five years, having increased by nearly 70 bps in three months, which has further weighed on the euro.
The Fed announces its interest rate decision on Wednesday and interest rate futures imply a 94% chance of a cut, even as services-sector activity leapt to a three-year high, according to an S&P Global (NYSE:SPGI) purchasing managers survey.
The Atlanta Fed's GDPNow indicator is running at 3.3% for the fourth quarter, and the strength of the economy has been lifting yields and supporting the dollar as traders figure that the neutral setting for rates may be higher than first thought.
"We're looking for the Fed to indicate more caution over future path of rate cuts. So 25 basis points is a done deal this week, but the key question is, obviously, what happens next year," MUFG currency strategist Lee Hardman said.
"We do think there's a higher likelihood that we will see the Fed skip the next meeting in January to leave rates on hold," he said.
U.S. President-elect Donald Trump takes office in January. He has already promised a raft of measures to impose tariffs on imports from the likes of China, Canada and Mexico, as well as the deportation of millions of undocumented migrants - both of which could contribute to a sustained pickup in inflation and prevent the Fed from cutting rates more deeply.
Fed officials' median long-run interest rate projection was 2.9% in September. Right now, market pricing implies almost no chance of rates being that low by December next year and only a 30% chance of the Fed Funds rate falling below 3.75% by the end of 2025.
RATE DECISIONS AHEAD
Price action across the currency market remained fairly contained on Tuesday, as traders held their fire ahead of the Fed, but also ahead of policy decisions from the Bank of Japan, Bank of England and Norges Bank on Thursday, which are expected to leave their respective rates unchanged. Sweden's Riksbank also meets on Thursday and is expected to cut rates by as much as half a point.
Sterling edged into positive territory on Tuesday after data showed regular UK pay rose more quickly than expected in the three months to October.
The BoE has frequently cited wage growth as one of the reasons for caution around cutting rates. A survey of British business activity on Monday pointed to rising price pressures.
The pound was last modestly up on the day at $1.26895.
The Canadian dollar, squeezed by falling interest rates and the risk of U.S. tariffs, sank to a 4-1/2 year low on Monday as the sudden resignation of Finance Minister Chrystia Freeland put an unpopular government under more pressure.
The yen strengthened a touch, leaving the dollar down 0.17% at 153.865 per dollar, after six straight days of selling, as markets have scaled back the chances of a Japanese rate hike this week in favour of a move in January.
The Australian and New Zealand dollars are pinned near the year's lows.
The Aussie was last down 0.4% at $0.6345, while the kiwi fell 0.4% to $0.576. New Zealand increased its bond issuance forecast for the next few years.
China's yuan was steady at 7.2915 per dollar, as dour expectations for Chinese economic growth pinned 10-year bond yields near record lows.
Chinese leaders agreed last week to raise the budget deficit to a record 4% of gross domestic product next year, while maintaining an economic growth target of around 5%, two people with knowledge of the matter told Reuters.