Dollar holds its breath as market awaits Fed policy decision

WASHINGTON, March 21 (Reuters) - The dollar pared earlier losses and sterling fell on Tuesday as traders reckoned banking stress could keep the Federal Reserve and the Bank of England from hiking interest rates much further, or at all, later in the week.

Investors' focus has moved to a slew of central bank meetings due this week after days of volatility in markets caused by worries over the stability of the global banking sector.

The dollar index fell 0.058% to 103.270, while sterling edged 0.59% lower to $1.2204.

Markets are pricing in an 85% chance of a 25-basis-point rate hike when the Fed announces its monetary policy decision on Wednesday. The peak for the Fed's benchmark overnight interest rate was seen at 5.5% only a few weeks ago, against about 4.8% now. IRPR

The dollar has followed those expectations lower, though general nervousness in financial markets has tempered selling.

Sentiment is fragile as investors are concerned over the outlook for the banking sector after shares of U.S. lender First Republic (FRC.N) tumbled nearly 50% on Monday on fears it will need a second rescue.

"(The Fed) should signal that inflation is still the focus here, but obviously properly address what has been done, and highlight what they can do to further prevent any further contagion beyond First Republic," said Edward Moya, senior market analyst at OANDA.

U.S. Treasury Secretary Janet Yellen told bankers on Tuesday that she is prepared to intervene to protect depositors in smaller U.S. banks that might be suffering deposit runs if they pose a risk of contagion.

"It seems that after a couple of weekends of pushing policy support and certain (Treasury) officials suggesting that they'll do whatever it takes to guarantee deposits, what it suggests to me is that hikes can go on," said Mazen Issa, senior FX strategist at TD Securities in New York.

Sterling moved a bit lower, staying close to an almost seven-week high against the dollar, after data showed Britain recorded a budget deficit of 16.68 billion pounds ($20.4 billion) in February, far above expectations in a Reuters poll.

On Tuesday, minutes from the Australian central bank's March 7 policy meeting showed officials had agreed to consider the case for a rate pause at the April meeting, even before the recent bout of volatility weighed on the Australian dollar , which fell 0.88% versus the greenback at $0.666.

"In places like Canada or Australia, where those central banks have essentially said that they're done with the interest rate tightening phase, those are the currencies that are lagging against the currencies where hikes still remain in the curve," Issa said.

The euro last was up 0.39% to $1.0761.

In cryptocurrencies, bitcoin last rose 0.32% to $28,168.00 after hitting a nine-month high on Monday. The world's largest cryptocurrency rose 26% last week, its best weekly gain since April 2019.

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Currency bid prices at 2:52PM (1852 GMT)