Dollar catches footing ahead of Fed

The dollar steadied on Wednesday as stronger-than-expected U.S. retail sales had traders slightly trimming bets that the U.S. easing cycle will begin with an outsized interest rate cut.

The Federal Reserve is expected to make its first interest rate cut in more than four years at 1800 GMT, which will be followed by a news conference half an hour later.

The dollar has fallen along with U.S. yields since July and at $1.1119 per euro is not far from the year's low at $1.1201 as traders anticipate easing at a clip, with more than 100 basis points of rate cuts priced in by Christmas.

It briefly fell below 140 yen in a holiday-thinned Asia session on Monday but changed hands at 142.02 yen early on Wednesday as a big week for the currency pair culminates with central bank meetings in the U.S. and, on Friday, in Japan.

August retail sales rose 0.1% in the U.S., data showed overnight, against expectations for a 0.2% contraction.

The Atlanta Fed's closely-followed GDPNow estimate was raised to 3% from 2.5% after the data. A rate cut is fully priced, with interest rate futures implying a 63% chance of a 50 basis point cut, after flirting with 70% a day earlier.

Traders say the Fed's tone as well as the size of the rate cut will drive the next moves in the foreign exchange market.

"A dovish Fed on a substantial easing path should generally lead to a weaker dollar," said Nathan Swami, head of currency trading at Citi in Singapore.

But an extremely dovish Fed, Swami said, could end up spooking markets if it seems the Fed anticipates a more ominous downturn in the economy than is expected, and in that case risk-sensitive and emerging market currencies may face headwinds.

China's stock, bond and currency markets resume trade on Wednesday after the mid-autumn festival break, though it is a holiday on Wednesday in Hong Kong. Ahead of the onshore open, the yuan traded at 7.1083 per dollar offshore.

The Australian dollar traded firmly at $0.6759 early on Wednesday while the New Zealand dollar ticked 0.1% higher, with help from higher milk prices, to $0.6194.

Sterling, the best performing G10 currency of the year, held at $1.3161 with its rally being driven by signs of a steadying economy and sticky inflation. British inflation data is due later in the day, while on Thursday the Bank of England is seen leaving rates on hold at 5%, with a 35% chance of a cut.

Final European inflation figures are also due, however they are unexpected to deviate much from preliminary August figures and so all eyes will be on the Fed.

"With markets wagering on 41bp of cuts, which is a long way from either realistic contender (25bp or 50bp), volatility seems almost assured," analysts at ANZ Bank said in a note to clients.