Dollar Slides on Sharp Fall in US Business Index

The dollar fell to two-week lows Thursday after data showing a much sharper-than-expected contraction in U.S. Mid-Atlantic factory activity this month made investors brace for more Federal Reserve rate cuts.

Futures markets have almost fully priced in another half percentage point rate reduction at the Fed's March meeting, up from an 82 percent chance seen before the sharp fall in the Philadelphia Federal Reserve's business index.

More U.S. rate cuts would further erode the dollar's appeal to global investors, particularly when central banks in Europe and Australia are keeping rates steady or raising them.

"(The Philadelphia Fed survey) is a big black eye for dollar bulls. It's really starting to confirm the notion that the U.S. economy is slowing considerably," said Boris Schlossberg, senior currency strategist, at DailyFX.com in New York.

The euro rose to two-week highs against dollar at $1.4800, according to Reuters data, then slipped slightly lower, but remained up on the day. The dollar also dropped to two-week lows against a basket of major currencies at 75.686.

Against the yen, the dollar fell 0.4 slightly.

Minutes from the Fed's last policy meeting showed on Wednesday that policy makers are worried about still slower U.S. growth even after their series of aggressive rate cuts.

The Fed also lowered its U.S. growth forecast for 2008.

The Philadelphia Fed business activity index's decline to minus-24 in February -- its worst reading since 2001 – seemed to support that view. It also confounded economists who had expected a more modest reading of minus 11.

Readings below zero represent contraction in the industrial sector, which many believe could now be in recession. National data has been less dire, suggesting some regions are suffering more acutely from the housing slump than others.

"The Fed .... was basically saying that rate cuts will continue for the foreseeable future. They're seeing a more severe contraction than first meets the eye," Schlossberg said.

ECB Rate Cut Expectations Fade

In contrast to Fed expectations, investors are scaling back expectations for European Central Bank rate cuts this year as French inflation rose to its fastest annual pace in at least 11 years.

Futures market are now pricing in only a 1-in-4 chance of a rate cut from 4 percent by June. Just last week, a June rate cut had been fully priced in.

That should keep the pressure on the dollar, as investors have more incentive to hold higher-yielding euro-denominated debt over U.S. debt.

The euro also rose to five-week highs against the yen .

Sterling, meanwhile, gained 0.9 percent to $1.9591 thanks to an unexpectedly strong retail sales report which helped ease concerns about the health of the UK economy.

Soaring commodity prices are also on traders' radar screens. Gold and platinum hit historic highs, while silver hit a 27-year high, extending their recent rallies.

U.S. light sweet crude oil held near $100 a barrel , having hit a record high above $101 on Wednesday.

"If oil continues its upward trajectory, that will have people concerned about the impact of high oil prices on the U.S. economy and that could be negative for the dollar," said

Shane Enright, a currency strategist, at CIBC World Markets in Toronto.

Copyright 2008 Reuters. Click for restrictions.