* Euro drops as German and French economies contract in Q4
* Euro zone economy contracts more than expected
* ECB's Constancio says negative rates possible
By Anirban Nag
LONDON, Feb 14 The euro fell to a three-week low
against the dollar on Thursday after data painted a grim picture
of the euro zone economy as it struggles with the debt crisis
now in its fourth year.
Output in the 17-country euro zone slid by 0.6 percent in
the fourth quarter, more than the 0.4 percent decline expected
in a Reuters poll and deepening its recession.
The bloc's two largest economies, France and powerhouse
Germany, also shrank by more than expected in the final quarter,
casting doubt on forecasts of a recovery in early 2013.
That bolstered inflows into safe-haven German Bunds and
fanned expectations the European Central Bank will lower
interest rates in the next few months. ECB Vice President Vitor
Constancio said negative interest rates - where banks
effectively pay the central bank to hold their cash securely -
were still a possibility, although no decision has been made.
Those developments are likely to keep the euro off its
recent highs of above $1.37, and it hit a three-week low on
Thursday, falling 1 percent on the day to $1.33195 - well below
a one-week high of $1.3520 struck on Wednesday.
Against the yen, the euro was down 0.8 percent at
"The GDP numbers were weaker than expected and while it's
not dramatic, going forward if data continues to weaken and does
not reflect the improved financial conditions, we may see some
monetary policy response from the ECB," said Paul Robson,
currency strategist at RBS.
Those worries are likely to pin the euro down, he said.
The euro has risen 1 percent against the dollar and 9
percent against the yen this year after banks repaid some crisis
loans to the ECB, effectively tightening liquidity while both
the Federal Reserve and the Bank of Japan have been expanding
their balance sheets by printing more money.
And while figures earlier in the year from Germany showed
some signs the economy was stabilising, peripheral euro zone
countries have continued to struggle in the face of tough
austerity measures. Data on Thursday showed the recessions in
Italy, Portugal and Greece had worsened.
Financial conditions in the euro zone have improved,
however, with peripheral bond yields well below highs struck
last year, lending solid support to the euro.
"The GDP numbers are a bit backward-looking and the more
forward-looking indicators all show signs of stability," said
George Saravalos, G10 FX strategist at Deutsche Bank.
"We are neutral on the euro and expect it to finish the
quarter at $1.35."
CAUTION BEFORE G20
Investors will nonetheless stay cautious on the euro given
the risk of a tough statement on currencies from a G20 summit in
Moscow this weekend. Speculation has continued that the group of
industrialised nations may apply pressure on Japan to slow the
G7 nations - Britain, the United States, Japan, Germany,
France, Italy and Canada - said this week that fiscal and
monetary policies must be directed at domestic economies and not
at targeting exchange rates.
But confusion reigned after a G7 official said the statement
was aimed at Tokyo, a comment that prompted the yen to surge on
a volatile foreign exchange market. Other G7 countries later
said it should be taken at face value.
While the yen was higher against the euro, it slipped
against the dollar. The dollar traded at 93.54 yen, up
0.3 percent but still well below a 33-month high of 94.465 set
Earlier, the BOJ kept policy steady as expected and revised
up its assessment of the Japanese economy.
Some believe the BOJ might hold off on expanding stimulus
next month, and wait until the first rate review under its new
governor, scheduled for April 3-4.
BOJ Governor Masaaki Shirakawa will leave three weeks ahead
of the end of his five-year term, clearing the way for slightly
earlier implementation of aggressive easing under his successor.
"This is the BOJ's 'lame duck session,' so it is natural
that they didn't do anything today, and perhaps not next month,"
said Citibank Japan chief FX strategist Osamu Takashima.
"But the market expects monetary easing under the new
governor," he added.