* Dollar index touches near 2-week high
* Euro tests 22-month low versus British pound
* Euro zone data lags, weighs on euro (Updates, adds quote)
By Anirban Nag
LONDON, July 7 (Reuters) - The euro slipped on Monday, testing a 22-month trough against the British pound, after weak German industrial data highlighted the divergent economic prospects between the euro zone and those of its biggest trading partners.
German industrial output fell 1.8 percent on the month in May, its biggest drop in more than two years, surprising most analysts, who had forecast an unchanged reading.
The weak data kept alive expectations that the European Central Bank may need to loosen monetary policy further in coming months in the face of disinflationary pressures and subdued economic growth.
ECB policymaker Benoit Coeure said at the weekend that rates will remain very low for a long time, regardless of developments in the rest of the world.
In contrast, the Bank of England is expected to tighten policy either before the end of this year or early next year. Investors have also brought forward their view on the timing of the first rate hike by the U.S. Federal Reserve to mid-2015 after a stellar jobs report last week.
That helped the dollar index trade near its highest in nearly two weeks, at 80.359. The euro was down slightly at $1.3590, having fallen to $1.3576 earlier in the European session, its lowest since July 26. It fell to a 22-month low against the pound of 79.14 pence after the German data, but recovered to trade at 79.35 pence.
“The German data was a bit weak and in line with recent euro zone data. This will add to selling pressure in the euro in the near term,” said Yujiro Goto, currency analyst at Nomura.
He expected euro/dollar to drift lower, especially in light of last week’s U.S. jobs data. The strong non-farm payrolls report prompted traders to slightly increase bets that the Fed will lift rates in June next year.
Most traders, though, are cautious about adding to long dollar bets, aware that Fed policymakers will probably err on the side of caution or wait for wage inflation to pick up before hiking interest rates.
Fed minutes, due to be released later this week, should shed more light on how the debate within the rate-setting committee is shaping up, traders said.
“The FOMC minutes this week could reveal how the Fed views the recent rise in inflation and stronger data. The risk is that there is a divergence between the doves and the hawks on the committee,” Morgan Stanley analysts said in a note.
“With (Fed chair Janet) Yellen staying firmly dovish, the minutes may reflect this and has a chance to put the dollar under pressure.”
The dollar’s failure to make much headway has been the big disappointment on currency markets this year. Most traders say that unless two-year Treasury yields rise sharply, the dollar, which has a good correlation to U.S. yields, is unlikely to push much higher.
The dollar fell against the yen to 101.90 yen, after having risen 0.7 percent last week. The euro also shed 0.2 percent to trade at 138.51 yen with falling stock markets offering the safe-haven yen some support.
Sterling, however, slipped against the dollar to $1.7125, off last week’s six-year high of $1.7180. The Canadian dollar, also in favour at the moment, stood at C$1.0643 per USD , just off a six-month high of C$1.0620 struck on Thursday. (Editing by Hugh Lawson)