Euro drops; ECB rate cuts seen after weak data

NEW YORK (Reuters) - The euro underwent a broad-based decline on Tuesday as dismal euro zone service sector data fueled expectations the European Central Bank might follow the United States in cutting interest rates.

The dollar pared early U.S. gains versus the yen after a report showed a sharp drop in activity in the U.S. service sector as well in January. The weak data reinforced fears the economy is slowing even as the Federal Reserve cuts rates aggressively to revive growth.

The euro fell more than 1 percent against the dollar after figures showed service sector growth across the 15-nation bloc slowed in January to its most sluggish in 4-1/2 years. Germany, Spain and Italy registered contractions.

A separate report showed euro-zone retail sales defied expectations of a monthly rise in December and fell, underscoring a slowing economy.

"As an indicator of a slowing economy, this is the type of result that could sway the ECB toward a less hawkish stance at its interest rate announcement this week," said Wells Fargo FX Express in a note to clients.

In late trading in New York, the euro was down about 1.3 percent at $1.4640, on track for its steepest one-day loss since mid-December.

The euro's weakness against the dollar helped lift the greenback across the board despite the weak U.S. service sector data. The dollar index, a measure of the U.S. currency's value against a basket of six currencies, closed up 1 percent at 76.116 .DXY, its biggest one-day percentage advance since mid-December and moving further away from two-month lows struck last week.

The sharp drop in European data "played straight into the hands of the euro bears, supporting their argument that the ECB will not be able to remain hawkish much longer and will have to follow the Fed by lowering rates relatively soon," said Boris Schlossberg, chief currency strategist for DailyFX.com.

The ECB meets to set interest rates on Thursday and is expected to keep them on hold at 4 percent.

Against the yen, the dollar traded 0.2 percent higher at 106.87 yen after earlier climbing as high as 107.74. The U.S. currency gave up almost all its gains after the dismal showing in the Institute for Supply Management's non-manufacturing index. The index plummeted in January to levels not seen since the 2001 recession.

"The data is extremely dollar-negative, although the inability to sustain dollar losses last week will keep the market skittish and follow-through will be restrained," said Alan Ruskin, chief international strategist at RBS Greenwich Capital.

AGGRESSIVE STANCE

The Fed's aggressive rate cuts in recent months lent some support to the dollar as investors took the view the bold action would sustain the U.S. economy and fuel a recovery later in the year.

The Fed has already slashed its key rate by 225 basis points and is seen cutting at least another 75 by the end of the year. Futures markets expect the ECB to cut rates by 50 basis points by the third quarter and are split on a further quarter-percentage-point easing before the end of the year.

The Bank of England also meets to set rates on Thursday and is expected to cut borrowing costs a quarter of a percentage point to 5.25 percent. It would be its second rate cut in three months.

Australia's dollar dropped even as benchmark borrowing costs rose to an 11-year high of 7 percent. The Aussie dollar traded down 1.5 percent at $0.8950.