Dollar falls to record low vs euro on subprime scare

NEW YORK (Reuters) - The dollar fell to a record low against the euro and a 26-year low against sterling on Tuesday as investors feared that the deteriorating U.S. subprime mortgage market could eventually slow the economy.

The dollar's broad decline was relentless late into the session and was steepest against the yen and Swiss franc, low-yielding currencies that benefited as investors cut back on their exposure to riskier, higher-yielding assets.

The sell-off was sparked by a report from credit rating agency Standard & Poor's that it may downgrade $12.1 billion in subprime-related debt. Subprime loans are extended to borrowers with poor credit.

"Despite being a traditional 'safe haven' currency, the dollar is unlikely to benefit ... given that the U.S. is the locus of problems," said CitiFX analysts in a note. "In turn, the Swiss franc and the yen are due to strengthen disproportionately as a result," they said.

The euro rose as high as $1.3742 against the dollar, a record high, according to electronic trading platform EBS. It ended the day near the highs, at $1.3729, up 0.7 percent on the day.

Sterling climbed to around $2.0274 against the dollar, the highest in 26 years, according to Reuters data.

Against the yen, the dollar fell to a one-month low around 121.8, down more than 1 percent for its biggest decline since mid-March. The dollar weakened 1.1 percent to a two-month low of 1.2028 Swiss francs, the largest fall since November 2006.

Against a basket of major currencies, the dollar fell to a two-and-half-year low of 80.815 .DXY.

"The market is seen in the process of forming a potentially significant bottom (in the dollar index) with as much as nine to 12 months of gains and 12-point rise after, but there are still no firm signs that this period of bottoming is complete," said David Solin, partner with Foreign Exchange Analytics.

The subprime news pushed U.S. stocks and Treasury yields sharply lower.

Implied volatility of major currencies along with stock option volatility ticked up, contributing to the pullback in risk-taking among investors.

STEADY FED, WEAK DOLLAR

The dollar was particularly vulnerable to the re-emergence of subprime concerns, which have nagged on investors all year, since expectations have increased the Federal Reserve will keep interest rates steady this year while other central banks raise rates.

Widespread housing sector weakness has the potential to drag on economic growth and raise expectations for an interest rate cut by the Fed.

"This concern offsets the recent string of economic data that had shown the U.S. economy had finished the second quarter with good momentum," said Marc Chandler, head of global currency strategy with Brown Brothers Harriman.

Benchmark U.S. rates have held at 5.25 percent for more than a year, reducing the dollar's appeal to global investors when other major central banks such as the European Central Bank are raising rates.

Furthermore, the spread of the implied U.S. interest rate in December 2008 over the euro zone's narrowed to 49 basis points, down sharply from around 70 basis points a month ago.

The ECB is expected to hike rates again in September to 4.25 percent, with some economists betting on a follow-up quarter-point hike to 4.5 percent by the end of the year.

The Bank of Canada, meanwhile, raised interest rates to 4.50 percent earlier on Tuesday. The U.S. dollar rose 0.2 percent against the Canadian dollar to C$1.0514, benefiting modestly from the Canadian central bank's less hawkish monetary policy statement.

"It's still an interest rate differential game," said Gregory Salvaggio, a vice president for trading at Tempus Consulting in Washington.