FOREX-Ireland downgrade hits euro, dollar extends rally

* Ireland downgrade pushes euro down toward $1.38

* Dollar index hits highest since May 20

* 2-year U.S. yields jump to highest in 7 months

(Updates prices, adds quotes, changes byline, changes dateline)

By Steven C. Johnson

NEW YORK, June 8 (Reuters) - The euro slumped against the dollar on Monday as another sovereign downgrade for Ireland helped the U.S. currency add to gains booked last week on rising Treasury yields and better-than-expected jobs data.

Ratings agency Standard & Poor's cut Ireland's sovereign credit rating on Monday to AA, its second downgrade in three months. That provided a fresh catalyst to sell the euro, which fell to $1.3806, almost a two-week low.

It also helped the dollar, which rallied Friday after data showed the United States lost fewer jobs than expected in May, extend gains. The jobs data triggered speculation the Federal Reserve may raise interest rates next year, pushing two-year government bond yields up sharply to a seven-month high.

"The euro was under pressure after last week's dollar bounce and the downgrade puts further pressure on it now," said Geraldine Concagh, economist at AIB Group Treasury in Dublin.

The euro fell as low as $1.3806, according to Reuters data, and was last down 0.7 percent on the day at $1.3875 EUR=. Against the yen, the euro was down 0.9 percent at 136.49 yen.

An index that gauges the dollar's value against six major currencies was up 0.5 percent on the day after earlier hitting its highest since May 20. On Friday, it rose 1.6 percent, the index's best performance since Dec. 19, Reuters data showed.

The dollar slipped 0.3 percent against the yen to 98.36 yen JPY=, still close to Friday's one-month high of 98.90 yen on trading platform EBS.

Sterling lost 0.3 percent to $1.5926 GBP= as British Prime Minister Gordon Brown faced a renewed leadership challenge after support for his ruling Labour Party in European elections plunged to its lowest level in a century.

"It's not obvious that the government is going to fall but it's definitely a risk," said BNP Paribas strategist Sebastien Galy. Even if the dollar rally runs out of steam this week, he said sterling may continue to suffer.

VIGILANT FED

Even before Ireland's downgrade, the dollar was buoyed by investors' focus on improving prospects for the U.S. economy, reversing a trend where the dollar had been sold for higher risk currencies in response to better economic fundamentals.

The pace of U.S. job losses slowed sharply last month, the strongest sign to date that the recession is diminishing, even as the unemployment rate hit its highest in nearly 26 years.

The spike in two-year yields forced more investors to unwind bets against the U.S. currency as some analysts said the dollar's earlier slide had been excessive. Two- and 10-year U.S. yields hit their highest levels since November in Asia on Monday as Treasuries extended losses.

This has raised expectations the Fed will hike rates sometime in early 2010, a view that was reinforced when Atlanta Fed President Dennis Lockhart said on Friday the Fed needs to be "anticipatory" and not wait too long before tightening policy.

However, Dennis Gartman, an independent investor and author of The Gartman Letters, said investors were jumping the gun.

"We shall mince no words here: this is not going to happen," he said, adding the Fed will wait until it is certain the recession is over and the jobless rate stops rising.

With currency movements closely following U.S. bond yields, markets will focus on a slew of Treasuries auctions this week. The U.S. government is scheduled to sell $65 billion in debt including 10-year and 30-year securities.

(Additional reporting by Harpreet Bhal and Jamie McGeever in London; Editing by Chizu Nomiyama )