* Seoul shares drop 1 pct, Tokyo's Nikkei down 1.2 pct
* Dollar near 2-year low vs euro, 2-week low vs yen
* Aussie, kiwi dollars weak, Indonesia's rupiah rises
By Dominic Lau and Vidya Ranganathan
TOKYO, Oct 25 A stronger yen depressed Japanese stocks on Friday, while the dollar was hemmed in near a two-year low against the euro by expectations the U.S. Federal Reserve will continue its monetary stimulus well into 2014.
Those expectations were tempered, however, by continued worries over tighter cash markets in China, leading to a lopsided and selective rally in Asian markets.
The Indonesian rupiah rallied more than 1.5 percent against the weak dollar, but the Aussie was on the backfoot.
Korean stock markets fell as investors braced for some profit-taking in a market that has seen record foreign buying for 40 consecutive sessions and has pushed the won to a two-year high this week.
The KOSPI index was down 1 percent even after Samsung Electronics Co Ltd, the index's largest component, said its quarterly operating profit surged 26 percent to a new record.
"A combination of foreign outflows and shadows of China liquidity concerns are dragging on the market," said Lee Kyung-soo, an analyst at Shinyoung Securities.
MSCI's broadest index of Asia-Pacific shares outside Japan eased 0.3 percent, reversing earlier slight gains. The index fell 0.1 percent on Thursday as rising Chinese money market rates countered signs of a pick-up in manufacturing.
In Tokyo, the Nikkei share average shed 1.2 percent as the dollar languished near a two-week low against the yen. It was on track to suffer its first weekly drop in three weeks.
Although the Japanese quarterly earnings season is still at an early stage, 70 percent of the 10 Nikkei companies that have reported so far have missed market expectations, according to Thomson Reuters StarMine. That compared with 42 percent in the previous quarter.
U.S. S&P E-mini futures were flat in early trade. The S&P 500 index had advanced 0.3 percent on solid earnings and expectations that monetary stimulus will be in place for the foreseeable future after weak data.
U.S. manufacturing output fell for the first time in four years and the number of new claims for unemployment benefits fell less than expected last week. .
The euro was steady at $1.3796, not far from a two-year high of $1.3826 touched on Thursday and shrugging off data showing the pace of growth in euro zone business unexpectedly eased this month.
"The dollar will not rally without Fed tapering expectations rising again, but we would not chase EUR/USD higher here, as rate compression suggests the pair is unlikely to break much higher," Societe Generale analysts wrote in a note, saying they favoured Scandinavian and Antipodean currencies into year-end.
"Fed tapering expectations being pushed out into 2014 and further ECB easing early next year suggest a favourable policy environment for the FX carry trade. Throw in lower volatility and seasonality effects, and one has the perfect cocktail for the carry trade."
Yet the Antipodeans, the Aussie and New Zealand dollars, were nursing broad losses too as investors quit extended long positions in the two currencies.
The Aussie was settling around $0.9600, after touching a low of $0.9582. It had hit a 4-1/2-month peak of $0.9758 on Wednesday, but is on track for a loss of close to 1 percent for the week.
The kiwi was holding just above a 10-day low at $0.8310. It had also peaked during the week at a multi-month high, but now faces a weekly loss of more than 2 percent.
Risky assets had been hit by talk that China was tightening cash supply to counter inflation risks and curb shadow banking, which led to a spike in short-term money market rates in China.
China's central bank, which sparked a market panic in June by engineering a cash crunch, refrained from taking part on Thursday in scheduled money market operations for the third consecutive time.
It has drained more than 157 billion yuan ($26 billion) from money markets since the week of Sept. 30. In response, China's seven-day repurchase rate - a benchmark for short-term funds - has jumped by 150 basis points this week to levels around 5 percent.
"In our view, the talk of the Chinese tightening was a bit of a red herring. It coincided with, and perhaps offered an excuse to take advantage of the long run up for the Antipodeans," said Westpac senior strategist Imre Speizer.
"For both, the broader story remains (U.S.) dollar weakness, and the high-beta currencies to perform well against it."
Against the yen, the dollar stood at 97.23, a shade off the two-week low of 97.15 yen hit on Wednesday.
The dollar index, which tracks a basket of major currencies, was little changed.
Gold paused for breath after climbing 1.1 percent on Thursday, while U.S. crude prices added 0.3 percent to about $97.35 a barrel, moving away from a 3-1/2 month low of $95.95 touched in the previous session.