Dollar declines as lawmakers duke out debt plan

One hundred Euro banknotes lay on top of various Swiss Franc notes in this picture illustration at a bank in Warsaw, July 18, 2011.

NEW YORK (Reuters) - The dollar dropped broadly on Tuesday and investors expected it to continue to depreciate as long as U.S. lawmakers fail to reach a compromise on a budget plan to prevent the country from defaulting on its debt.

The dollar hit a record low against the Swiss franc, a traditional safe haven, falling below a key option barrier at 0.80 franc. It also dropped to a four-month trough versus the yen and a three week low versus the euro.

A warning from President Barack Obama that failure to raise the U.S. borrowing limit by the August 2 deadline would severely hurt the nation sparked selling of the dollar and tarnished its traditional safe-haven appeal.

"The U.S. debt ceiling impasse is killing the dollar," said Kathy Lien, director of currency research at GFT Forex in New York.

Democrats appear willing to accept a deal that does not include tax increases, but it remains unclear whether there will be a temporary increase in the debt ceiling or a more permanent one that persist through the November 2012 presidential election.

"Unfortunately this continued uncertainty has proven to be extremely bearish for the U.S. dollar and until the debt ceiling is increased, the greenback will remain under pressure," Lien added.

While the dollar has dropped smartly, it could fall even further if the deficit reduction plan falls short and triggers ratings changes by Standard & Poor's, Moody's or Fitch.

Indeed, according to a Reuters poll of economists, the U.S. will lose its top-notch AAA credit rating from at least one major rating agency.

Executives at Standard and Poor's and Moody's Investors Service are scheduled to testify before Congress on Wednesday.

A downgrade of the credit rating of the U.S. is a bigger risk than a default and could add up to 0.7 percentage point to bond yields over time, members of U.S. securities industry group SIFMA said on Tuesday.

While a risk of a U.S. credit ratings downgrade remains even if an agreement to increase the debt ceiling is reached, it may not be as dire for the dollar as some assume.

"We believe that a credit downgrade would be negative for the U.S. dollar were it to occur, but the impact should be moderate rather than extreme," said Nick Bennenbroek, head of currency strategy at Wells Fargo in New York.

"Past experience hints at a dollar decline of perhaps 3 percent to 5 percent in the months following a credit rating downgrade."

The euro hit a session high of $1.4525, its strongest July 5. It was last at $1.4518, up 1 percent.

The dollar hit a record low versus the Swiss franc at 0.79970 franc on trading platform EBS. Against the yen, another safe-haven rival, the dollar also fell, hitting 77.828 yen, its weakest since mid-March, when major central banks acted in concert to stem the yen's rise.

Against a currency basket .DXY, the dollar fell 0.8 percent to 73.498, its weakest since early June.

U.S. Treasury auctions totaling $99 billion this week could serve as an important gauge of investor demand for government debt as the Washington stalemate persists.

Treasury sold $5 billion worth of two-year notes Tuesday in an auction that economists said went well.

(Additional reporting by Gertrude Chavez-Dreyfuss; Editing by Theodore d'Afflisio)