Dollar cruises toward best month in 2-1/2 years

A U.S. dollar bill is displayed in Toronto in this posed photo, March 26, 2008.

NEW YORK (Reuters) - The dollar headed for its best monthly performance in 2-1/2 years against a basket of major currencies on Friday, boosted by a growing view that the Federal Reserve may stop cutting interest rates.

U.S. economic data this week showing resilience in some sectors, such as the labor market, contrasted with a sharp drop in business sentiment in Germany.

That news, combined with European Central Bank policy-makers' comments highlighting worries about excess volatility in foreign-exchange trading, dampened expectations for a rate hike in the euro zone and hurt the euro.

"It's a major shift in sentiment regarding the outlook of interest rates and we may see the dollar strengthening until the next Fed meeting," said Mark Meadows, a market analyst at Tempus Consulting in Washington.

The perceived odds of the Fed keeping its benchmark interest rate unchanged at 2.25 percent at its meeting next week rose to about 26 percent, futures trading shows. Just over a week ago, futures were evenly split between a 25- and a 50-basis-point cut.

Meanwhile, traders are paring bets that the ECB's next move will be a hike in benchmark interest rates.

"Europe is really not insulated and its economy is beginning to show signs of a slowdown," Meadows said. "While most people now believe the Fed is about to end its easing cycle, a growing number of investors believe the ECB may have to start cutting rates really soon."

In late trading in New York, the euro was down 0.6 percent

at $1.5598 EUR=, after dropping as low as $1.5555 earlier, a three-week low.

The dollar index, which tracks its performance against a basket of major currencies, earlier hit a one-month high of 73.030 .DXY. It last traded at 72.818, putting it on track for its best monthly performance since November 2005 at current prices.

The dollar last traded up 0.1 percent at 1.0363 Swiss francs CHF= and it was up 0.2 percent against the Japanese yen at 104.47 JPY=.

The Japanese yen failed to benefit from news that Japanese core consumer prices rose at their fastest pace in a decade in March JPCPI=ECI.

The U.S. currency did surrender some gains earlier in the day after news a cargo ship contracted by the U.S. military fired at least one shot toward an Iranian boat.

Immediately after the news, the dollar declined sharply against both the yen and Swiss franc currencies, but then bounced back as there were no further reports of hostilities.

This week's rally in the dollar may have also led some investors to sell the currency ahead of the weekend to cash in profits, traders said.

"After the run in the dollar this week, investors would rather take the opportunity and sell some of it to book in some profits ahead of the weekend," said Joe Manimbo, a currency trader at Ruesch International in Washington.

The dollar had limited reaction to a report showing U.S. consumer confidence fell for a third straight month, touching its weakest in more than a quarter century.

In Europe, the Ifo German business sentiment index this week showed the biggest monthly fall since September 2001 on Thursday, taking the April headline number to a two-year low.

Together with a soft euro-zone manufacturing survey, the data knocked the euro off record highs above $1.60 set at the start of the week.

(Reporting by Nick Olivari and Vivianne Rodrigues; Editing by Jan Paschal)