FOREX-Dollar logs weakest quarter vs euro since 2004

(Recasts, updates prices, adds comments, detail, byline)

By Steven C. Johnson

NEW YORK, March 31 (Reuters) - The dollar was headed on Monday for its biggest quarterly loss against the euro in four years after a sharp gain in euro zone prices reinforced the divergent paths of U.S. and European benchmark interest rates.

A report showing annual euro zone consumer prices rose in March at their fastest pace since the euro was launched in 1999 sent the zone's common currency as high as $1.5895, just shy of a record peak set two weeks ago, before investors booked profits and pushed it back to $1.5785 EUR= in late trade.

The euro remained up 8.2 percent against the dollar this year, however, on track for its biggest quarterly gain since 2004.

"The euro's upward trend lost some momentum today but that doesn't change the underlying bearish dollar sentiment," said Matthew Strauss, currency strategist at RBC Capital Markets in Toronto.

"Although some came into the year thinking the worst was behind us, the first quarter was clearly one in which markets struggled to get a handle on just how deep the problems in the U.S. economy really were," he added. "And to call a bottom now is still a very risky call. It's too early to say the worst is behind us and the dollar's in for a sharp rebound."

The euro zone data left traders betting an inflation-weary European Central Bank would leave interest rates on indefinite hold at 4 percent. The Federal Reserve, though, is widely expected to cut rates further to boost economic growth, making dollar-denominated assets less attractive to global investors.

The dollar index .DXY, a gauge of the greenback against a basket of major currencies, was down 6.4 percent this year, also targeting its worst performance since the fourth quarter of 2004.

Against the yen, the dollar was up 0.6 percent from late Friday at 99.69 yen JPY= as fiscal year-end activity from Japanese investors and corporates kept the currency under pressure, traders said.

So far this year, though, the dollar has lost more than 10 percent against the yen, its poorest showing since the third quarter of 1999.

DOLLAR AS FUNDING CURRENCY

The biggest problem for the dollar heading into the second quarter remained expectations of lower interest rates.

The Fed has already slashed rates by 3 percentage points since September in a bid to restart flagging growth, pushing the federal funds rate to 2.25 percent, the second-lowest among major economies, after Japan.

On an inflation-adjusted basis, U.S. rates are now the lowest in the developed world, and that keeps pressure on the greenback by encouraging investors to borrow dollars cheaply to finance purchases of higher-yielding currencies and assets.

"The U.S. economic malaise has been as bad as everyone envisioned, and by accelerating its rate cuts, the Fed has turned the dollar into an instant funding currency," said Adam Fazio, currency strategist at CIBC World Markets in New York.