By David McIntyre and Stanley White
May 4 (Bloomberg) -- The dollar headed for the biggest weekly gain in four months against the euro as strength in U.S. manufacturing and services suggested the Federal Reserve will refrain from cutting interest rates in coming months.
The dollar also was set for a second winning week versus the yen, to the strongest since February, as the yield spread between U.S. and Japanese two-year bonds widened to a three-week high. The U.S. Institute for Supply Management's index of services grew the fastest in three months in April, while manufacturing was the best in almost a year.
``The data don't support the idea the economy is falling into a hole, pricing out the possibility of the Fed cutting rates,'' said Tony Morriss, a currency strategist at Australia & New Zealand Banking Group Ltd. in Sydney. ``The yield differential has moved in the dollar's favor.''
The U.S. currency was poised for its first weekly gain in six against the euro, rising to the strongest since April 17 at $1.3536, before trading at $1.3545 at 6 a.m. in London. The dollar bought 120.31 yen and touched 120.47, the highest since Feb. 27. It rose 0.6 percent from 119.63 yen in New York last week.
The dollar index, measuring its value against six major currencies, climbed 0.56 percent this week, the most in two months. The four-day rally was the longest this year. Trading may be subdued in Asia due to holidays in Japan and China.
The yield premium on U.S. two-year Treasuries over similar- maturity Japanese bonds was 3.84 percentage points, the widest since April 16. It was 3.79 percentage points last week. The Fed's 5.25 percent benchmark rate compares with 0.5 percent for the Bank of Japan, 3.75 percent for the European Central Bank and 6.25 percent for the Reserve Bank of Australia.
Fed Futures
The dollar yesterday rose for a fourth day as the ISM's index of non-manufacturing businesses increased to 56 from 52.4 in March. Readings above 50 point to growth in services such as banking, retailing and construction, which make up almost 90 percent of the U.S. economy.
Interest-rate futures show 17.5 percent odds the Fed will lower borrowing costs in August, down from 22.5 percent a week earlier. Futures indicate any reduction in rates isn't likely until December, when a quarter-percentage point cut is fully priced in.
The yen headed for a second weekly gain against the Australian dollar after the Reserve Bank of Australia lowered its 2007 inflation forecast to 2.5 percent from 2.75 percent, weakening the case for a rate increase.
Unwinding Carry Trades
Australia's dollar had the biggest drop among the 16 most- active currencies as investors may exit carry trades involving borrowing yen to buy higher-yielding assets.
``The RBA may not hike this year,'' said Lee Wai Tuck, a currency strategist at Forecast Singapore Ltd. ``This may spur some unwinding of Australian dollar-yen carry trades.''
Australia's currency slipped the most in two weeks, to 98.54 yen from 99.23 yesterday. It may fall to 98.30, Lee said.
The euro, another beneficiary of yen carry trades, headed for its first weekly loss in nine. It was last quoted at 162.93 yen, down 0.2 percent from 163.27 last week.
The dollar may draw added support as improving economic data suggest a report on the U.S. labor market may beat expectations.
The U.S. economy created 100,000 new jobs in April, slower than the 180,000 jobs added in the previous month, according to the median estimate of 85 economists surveyed by Bloomberg before a government report due at 8:30 a.m. in Washington.
``We have an above-consensus expectation for a 115,000 increase, which would add to the sense that U.S. data are holding firm,'' said Sue Trinh, currency strategist at RBC Capital Markets in Sydney. ``We no longer expect the Fed to cut rates this year. This is absolutely supportive for the dollar,'' which may rise to 121.50 yen and $1.35 per euro today.
Put Up Rates
The euro may trim losses against the dollar on speculation reports on European services and retail sales today will reinforce expectations the central bank will raise rates further this year.
Royal Bank of Scotland Group Plc's services index rose to 57.6 in April, the fastest pace in three months, from 57.4 in March, a Bloomberg survey shows. Retail sales in the 13 nations that share the euro grew 2.3 percent in March after rising 1.2 percent in February, a separate survey shows.
``In Europe, the view is the economy is getting stronger and stronger,'' said Michael Thomas, head of economics and strategy at ICAP Australia Ltd. in Sydney. ``The Europeans are just about to put up rates again. The euro is probably heading back up'' to $1.3700 and 165.77 yen next week, he said.
Interest-rate futures indicate investors anticipate the ECB will increase borrowing costs twice more this year. The yield on the December contract was 4.375 percent yesterday, above 4.355 percent a week earlier.
The contract settles to the three-month interbank offered rate for the euro, which has averaged about 16 basis points above the ECB's benchmark since 1999.
To contact the reporter on this story: David McIntyre in Sydney at dmcintyre2@bloomberg.net ; Stanley White in Tokyo at swhite28@bloomberg.net .
Last Updated: May 4, 2007 01:04 EDT
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