NEW YORK The dollar gained broadly on Tuesday, hitting a 10-week high against the euro after warnings from two credit ratings agencies sparked fear that a deep recession in Eastern Europe would cause further damage to banks in the euro zone.
The yen also fell after earlier data showed Japan's economy shrank in the fourth quarter at its fastest clip in 35 years and the country's finance minister resigned, putting pressure on the government.
The euro fell below $1.26 for the first time since early December after Moody's Investors Service threatened to downgrade euro zone banks with significant exposure to the weakening economies in Eastern and Central Europe.
Standard & Poor's also said it may review emerging Europe bank ratings now that the credit crisis has limited Western European banks' ability to fund subsidiaries in the region.
"That's pretty negative for the European economic outlook and certainly implies that the (European Central Bank) has more work to do," said Robert Blake, senior currency strategist at State Street Global Markets in Boston.
"It's a pretty significant story that's not going away and may only get worse. That's certainly a negative for the euro," he said.
The euro was last down 1.3 percent at $1.2602 after earlier falling as low as $1.2564, its lowest level since December 4. It fell 0.7 percent to 116.31 yen.
The dollar rose 0.6 percent to 92.30 yen, not far from a one-month peak at 92.75 hit earlier. The ICE futures' dollar index, a gauges of the greenback against six major currencies, rose 1.3 percent to 87.637 .DXY after earlier hitting 87.864, its best showing since November.
The strong yen and the deep recession in the United States and other markets for Japanese exports has rattled Japan's economy, which in the fourth quarter contracted at its fastest pace since 1974.
"The yen is acting like a hostage with a bag over its head and a noose around its neck, and that's because without U.S. consumption driving global growth forward, Japan's in big trouble," said Andrew Wilkinson, senior market analyst at Interactive Brokers Group in Greenwich, Connecticut.
With the Japanese and euro zone economies floundering, the dollar becomes just about the only short-term alternative, analysts said.
"The dollar's been the big winner today and I can't see any reason not to keep holding the world's major reserve currency," Wilkinson said, who said he expects the euro to keep grinding lower toward $1.15 over the coming quarters.
Investors' demand for safety that fed dollar gains on Tuesday also pushed U.S. government bond yields down and sent spot gold to a seven-month high.
That came even as U.S. economic data painted a grim picture, with the New York Federal Reserve reporting its manufacturing activity index plunged to a record low this month.
A separate Treasury Department report was more encouraging, showing foreigners bought a net $34.8 billion in long-term U.S. securities in December, reversing outflows in the prior month. That too was tied to safe-haven flows, analysts said.
The data eased worries that foreign investors, especially China, are backing away from U.S. assets.
(Additional reporting by Wanfeng Zhou; editing by Gary Crosse)