FOREX-Euro drops vs dollar, pound on worry over Russia sanctions hit
* Euro falls against dollar, sterling, yen
* EU threatens Russia with harsher sanctions
* Sanctions seen hitting fragile euro zone growth
* BoE minutes fail to boost rate hike expectations
By Jemima Kelly
LONDON, July 23 (Reuters) - The euro hit an eight-month low against the dollar on Wednesday as worries over tougher sanctions on Russia and their potential impact on fragile euro zone growth drove investors away from the single currency.
Harsher steps could be a particular hit to euro zone powerhouse Germany given its strong trade links with Russia.
The European Union (EU) on Tuesday threatened Russia with additional penalties over Ukraine following the downing of a Malaysian airliner last week. Foreign ministers for the first time raised the possibility of restricting Russia's access to European capital markets.
The euro touched $1.3455, its lowest since November 2013 and investors expected more losses in coming days. The single currency was flat at 136.60 yen, having hit a 5-1/2-month low hit earlier in the day.
"There is quite broad-based pressure building on the euro and there are a number of factors driving that. Europe is directly exposed to Russia by trade - Germany in particular - so sanctions could potentially have a negative impact on the euro," said Ian Stannard, a currency strategist at Morgan Stanley.
The euro hit a near two-year low against the British pound of 78.69 pence before recovering to 79.07 pence, up 0.2 percent on the day, after Bank of England minutes failed to boost expectations of an interest rate hike by year-end.
In fixed income markets, German government yields fell close to record lows on concern over the potential harm more sanctions on the EU's third-biggest trading partner could cause to the euro zone.
European stocks rose as forecast-beating earning offset sanctions worries. However, the Euro STOXX 50 index of euro zone blue-chips is down 0.8 percent since the end of June, compared with a 1.3 percent rise in the U.S. S&P 500 .
Morgan Stanley's Stannard said comments overnight from Chinese officials, suggesting there have been capital outflows from China, would imply that Beijing's reserve accumulation is slowing, reducing the need for the purchase of alternative reserve currencies of which the euro has been a beneficiary.
Traders said it was significant that the euro had closed below $1.35 on Tuesday for the first time this year, making the currency appear technically weak. It could fall below reported option barriers at $1.34 in the coming days if flash PMI and German IFO data disappoint, they said.
The dollar index, which tracks the greenback against a basket of six major rivals, was steady on the day at 80.747, not far from a Tuesday high of 80.837 touched on expectations that higher U.S. interest rates are on the horizon.
Data on Tuesday showed U.S. inflation was 0.3 percent in June, in line with forecasts, though core inflation, excluding food and energy prices, undershot expectations.
However, markets still expect the U.S. Federal Reserve to continue tapering its bond purchase programme and then raise interest rates in the latter half of 2015, in contrast with the European Central Bank which cut rates last month and has kept the door open to a large-scale asset purchase programme.
"Euro/dollar downside movement is mainly driven by the divergence in the economic growth of the two areas and the consequent different monetary policies," said Francesco Scotto, a portfolio manager at RTFX Fund Management.
"With the business confidence in Germany pointing south and the IMF's warning on the weak economic recovery in the euro zone, we should not be surprised by this movement."
The Australian dollar rose over half a percent to $0.9448 after higher-than-expected data on June underlying inflation dented expectations of future rate cuts. (Editing by Nigel Stephenson)