TOKYO (Reuters) - - The dollar fell to a fresh 20-month low against the euro on Monday, carrying over its weakness from late last week, when soft U.S. factory data reinforced expectations that the Federal Reserve will cut interest rates next year.
While the dollar later pared losses as traders shed some long-euro positions, expectations for narrower rate differentials between the United States and the euro zone would likely keep hurting the dollar, market players said.
The U.S. currency slumped on Friday after the Institute for Supply Management's survey of U.S. national manufacturing in November showed a contraction in the factory sector for the first time in three and a half years.
The ISM's key index fell to 49.5, the first time below 50 -- which indicates shrinking activity -- since April 2003. A dip below 50 has historically been a reliable predictor of Fed rate cuts, analysts say.
Besides the weak U.S. data, relatively mild reactions from European officials toward the euro's strength as well as expectations for further credit-tightening in the euro zone augur well for the euro, said a trader for a Japanese trust bank.
"A rate rise by the European Central Bank this week is considered virtually certain, and if ECB President (Jean-Claude) Trichet says something positive afterwards about raising interest rates next year, the euro could see further gains," the trader said.
After rising to a 20-month high around $1.3370 in early trade, the euro pared gains to stand at $1.3325 as of 0350 GMT. That was down slightly from around $1.3335 in late U.S. trading on Friday.
Vague market talk that sovereign names, probably Asian, may have sold euros above $1.3350, might have helped push the currency off its highs, said a senior trader for a major Japanese bank.
The euro continued its run of record highs against the Japanese currency to hit 154.14 yen on electronic trading platform EBS, before dropping back to 154.05 yen .
French Budget Minister Jean-Francois Cope said in an interview broadcast on TV5 television and Europe 1 radio on Sunday that the euro is "slightly strong" but is not hurting growth.
The euro had received a boost on Friday after news agency Market News International quoted central banking sources as saying that the euro would have to climb some distance before the ECB grew nervous about its impact on exports.
One source was reported to have told Market News that the ECB threshold is as high as $1.55.
RATES ON RADAR
Sterling pulled away from a 14-year high of $1.9849 hit on Friday to stand at $1.9785 .
The dollar was at 115.65 yen , erasing its losses after falling to session lows around 115.10 yen. It hit a four-month low of 114.97 yen on Friday on EBS.
Traders said the dollar would likely continue to take its cues from the outlook for rate differentials.
Currently, eurodollar futures imply that traders expect the Fed to conduct up to three quarter-point rate cuts by the end of 2007. U.S. benchmark short-term rates are now at 5.25 percent.
By comparison, the ECB is widely expected to raise rates by 25 basis points to 3.5 percent at a policy-setting meeting on Thursday and another 25 basis point increase is seen likely in February or March.
In addition to the ECB, the Bank of Canada, the Reserve Bank of Australia, the Reserve Bank of New Zealand and the Bank of England are all due to make rate decisions this week.
A Saudi aggression fighter jet targeted a citizen's car driving in Fara area of Kutaf district in Saada province overnight, killing the driver and injuring his friend, a security official said on Monday.
Scores of Saudi enemy soldiers were killed and injured on Sunday when the army and popular forces repelled a Saudi military attempt to sneak into Shurfah site in the border province of Najran, a military official said.
The operation was accomplished successfully against the Saudi
Saudi aggression warplanes have launched more than 49 airstrikes over the past hours on several residential areas across Yemen, a security official said on Sunday.
The airstrikes targeted the areas of Malahiz and Husama in Dhahir district, and areas Thuban, Masahif and Sdad in Bakim district of northern Saada province.