FOREX-Dollar gains, euro wobbles on East European fears

Tue Feb 17, 2009 7:04pm GMT

* Dollar hits 2-1/2 month high versus euro

* Moody's, S&P warn of deterioration in eastern Europe

* Dollar Index nears 3-month high on safe-haven flows (Recasts, adds comments, updates prices)

By Steven C. Johnson

NEW YORK, Feb 17 (Reuters) - The dollar gained broadly on Tuesday, hitting a 10-week high against the euro after warnings from two ratings agencies sparked fear that a deep recession in Eastern Europe would cause further damage to euro zone banks.

The yen fell after data showed Japan's economy shrank in the fourth quarter at its fastest clip in 35 years and the finance minister resigned, putting pressure on the government.

The main focus, though, was on the euro, which fell below $1.26 to its lowest level since early December after Moody's Investors Service threatened to downgrade euro zone banks with significant exposure to weakening economies in Eastern Europe.

Standard & Poor's also said it may review emerging Europe bank ratings now that the credit crisis has limited western European banks' ability to fund subsidiaries in the region.

"That's pretty negative for the European economic outlook and certainly implies that the (European Central Bank) has more work to do," said Robert Blake, senior currency strategist at State Street Global Markets in Boston.

"It's a pretty significant story that's not going away and may only get worse. That's certainly a negative for the euro."

The euro was last down 1.4 percent at $1.2595 after earlier falling as low as $1.2564, its lowest level since Dec. 4. It fell 0.8 percent to 116.21 yen .

The dollar rose 0.8 percent to 92.44 yen , not far from a a one-month peak at 92.75 hit earlier. The ICE futures' dollar index, which gauges the greenback's against six major currencies, rose 1.3 percent to 87.667 .DXY after earlier hitting 87.821, its best showing since November.

The yen normally rises in times of risk aversion, too, as investors seek low but steady returns, but it struggled against the dollar on Tuesday after a report showed Japan shank in the fourth quarter at its fastest rate since 1974.

Worries about Japan and Europe "will keep risk aversion high," said Matthew Strauss, senior currency strategist at RBC Capital Markets in Toronto. "There's nothing out there that suggests a change in sentiment."

That leaves the dollar as just about the only short-term alternative, analysts said. Steep stock declines on Wall Street and in Europe further fed dollar gains as investors sought the relative safety of dollar-denominated assets such as U.S. government bonds, which rallied broadly.

U.S. economic data also painted a grim picture, with the New York Federal Reserve reporting its manufacturing activity index plunged to a record low this month.

But a separate Treasury Department report was more encouraging, as it showed foreigners bought a net $34.8 billion in long-term U.S. securities in December, reversing outflows seen the prior month.

The data eased worries that foreign investors, especially China, are backing away from U.S. assets.

"Foreign demand returned to U.S. securities in December, supported by ongoing safe-haven buying of dollar-denominated deposits," said Michael Woolfolk, senior currency strategist at The Bank of New York-Mellon in New York.

(Additional reporting by Wanfeng Zhou and Vivianne Rodrigues; Editing by Diane Craft)

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