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Dollar Retreats vs. Euro After Midwest Contraction

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The dollar fell to its lowest level against a basket of currencies in two months on Tuesday as a deluge of U.S. data had investors discounting any pullback in the Federal Reserve's easy money policy any time soon.

Investors pared positions in favor of the greenback on worries about the economy after data showed business activity in the U.S. Midwest unexpectedly shrank in April to its lowest since September 2009.

(Read More: Consumer Confidence Jumps; Midwest Manufacturing Contracts)

The dismal data followed a string of other gauges in recent weeks that showed weakness, including last week's report showing weaker-than-expected U.S. first-quarter economic growth.

Other sectors of the U.S. economy, however, appeared to be somewhat resilient, with a report showing U.S. home prices rose in February at their fastest rate in almost seven years.

The Federal Reserve's policy-making committee began a two-day meeting that will end Wednesday with a statement that some believe could sound relatively dovish in response to recent weak economic data, with the Fed expected to continue with its bond-buying program.

(Read More: Wall Street Sees No End to QE Until at Least Next Year)

The European Central Bank, meanwhile, meets on Thursday, with a narrow majority of economists expecting a 25-basis-point cut in interest rates, according to a Reuters poll.

(Read More: ECB Rate Cut Just Became Even More Likely)

"We expect the Fed to recognize the weaker data lately, but not make a material change to policy," said Amanda Chow, forex strategist at CitiFX, a division of Citigroup.

"For the dollar, the Fed meeting is not as big a focus as Friday's payrolls report," she said.

The state of the U.S. labor market is a key factor in Federal Reserve policy, with the U.S. central bank expected to continue its asset purchase program, called quantitative easing, and keep interest rates low until there is a marked and sustained improvement in the sector.

The government will release April U.S. employment data on Friday with non-farm payroll growth expected to total 145,000 jobs, according to economists polled by Reuters.

Payrolls growth in March was much lower than expectations, at 88,000 jobs.

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"A very significant upside surprise may be positive for the dollar as it would confirm positive growth," Chow said. "The dollar, however, may slightly weaken should the number fall within the wide range of expectations."

The dollar index, which measures its value against a basket of six major currencies, earlier hit its lowest since the end of February at 81.598.

The euro rose as high as $1.3185, the strongest since April 17, after breaking above resistance around the London session high of $1.3120, according to Reuters data. It last traded at $1.3166, up 0.5 percent on the day, with traders citing buying by a German bank.

On the month, the euro rose about 2.8 percent against the dollar, its first monthly gain since January.

Inflation in the euro zone hit a three-year low and unemployment rose to a record high, data showed on Tuesday. Adding to worries, German retail sales unexpectedly fell in March while Spain's economy shrank for the seventh straight quarter in the first three months of the year.

Some analysts said that while a rate cut could see the euro initially fall, announcing further easing measures would be interpreted as a positive move by the central bank and this could lend the euro support.

A drop in U.S. government bond yields, which move inversely to price, has weighed on the dollar versus the yen. The yield differential between U.S. Treasuries and Japanese government bonds is a key driver of the currency pair.

The dollar last traded down 0.4 percent to 97.41 yen, having hit as low as 97.01 yen, the weakest since April 16. In April, the dollar rose about 3.4 percent against the yen, the largest monthly gain since January.

The Bank of Japan this month announced an aggressive plan of bond buying that entails buying $1.4 trillion in government bonds in less than two years.

While the dollar reached as high as 99.94 yen on April 11, there is an abundance of options barriers preventing it from hitting the key psychological and technical 100 mark.

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