* Euro wallows at two-week lows after sharp drop overnight
* Unexpected slowdown in inflation sparks ECB rate cut expectations
* Euro seen under pressure ahead of Nov 7 ECB meeting
* Dollar main gain if upcoming US ISM data positive
* Aussie holds above 2-week low after decent China data
By Hideyuki Sano and Ian Chua
TOKYO/SYDNEY, Nov 1 (Reuters) - The euro dropped to a two-week low on Friday after a surprise slowdown in euro zone inflation sparked speculation the European Central Bank may take action to bolster the economy.
Euro zone inflation dropped to a four-year low of 0.7 percent in October, compared to a forecast of a flat reading at 1.1 percent, and way under the ECB’s target of just below 2 percent.
“It should mean quite a lot for the ECB that inflation fell below 1 percent. The slowdown in inflation does not seem to be over yet,” said Sho Aoyama, senior market analyst at Mizuho Securities.
“They know Japan’s experience of deflation and that once deflation takes hold, it could take decades to get out of it. The ECB may not cut rates next week but it will imply it is ready to do so,” he added.
The euro fell to as low as $1.35385, its lowest since Oct. 17, and last stood at $1.3554, down 0.3 percent on the day, after having fallen 1.1 percent the previous day.
The currency is now flirting with important chart supports around $1.3550, including a level representing the 76.4 percent retracement of its Oct 16-25 rally and a 38.2 percent retracement of its rally since Sept.
The euro looks set to stay under pressure until the ECB’s next policy meeting on Thursday as other euro zone data also showed unemployment held at record highs in September, and included alarming revisions to previous months.
The common currency also lost ground against other currencies including the yen, hitting a two-week low of 132.985 yen.
Renewed pressure on the euro saw the dollar index rising to a two-week high of 80.418, pulling further away from a nine-month trough of 78.998 plumbed a week earlier.
The dollar, however, eased against the yen, dipping 0.2 percent to 98.14 yen to be off this week’s peak of 98.69, largely in a knee-jerk risk-off reaction to fall in U.S. and Japanese shares.
Still, in contrast to the euro zone, U.S. data was far more encouraging. Business activity in the U.S. Midwest surged past expectations in October as new orders hit their highest level since 2004, while weekly unemployment claims fell, countering recent evidence of soft economic growth.
The strong Chicago survey has fuelled speculation the national ISM survey of manufacturing, due later on Friday, could also surprise to the upside.
The upbeat data only served to keep alive some expectations the Federal Reserve might scale back stimulus at its December meeting, though most analysts still tip March as the window for a move.
The Australian dollar managed to hold above Wednesday’s two-week low of $0.9441 after two Chinese manufacturing surveys posted decent readings.
The final HSBC/Markit Purchasing Managers’ Index (PMI) showed China’s giant manufacturing sector grew at its fastest rate in seven months in October. China’s official PMI released earlier in the day put manufacturing growth at 51.4, the highest in 18 months.
The Aussie stood flat on the day at $0.9460.