* Expectations grow of euro zone quantitative easing
* Dollar falls vs yen, investors wary of emerging markets
By Laurence Fletcher
LONDON, Feb 3 (Reuters) - The euro hit a two-month low against the dollar on Monday as expectations grew of radical European Central Bank action to head off the risk of deflation, while emerging market gloom helped push the U.S. currency down versus the yen.
The euro, which fell on Friday after weaker-than-forecast inflation data from the currency bloc, also plumbed a two-month trough against the yen and dropped to its lowest in more than six weeks against the Swiss franc.
The euro tumbled as far as $1.34765, its weakest since late November. It later recovered some ground to trade up 0.1 percent at $1.3499.
Euro zone inflation for January showed a surprise drop to 0.7 percent year-on-year. Analysts had expected prices to rise 0.9 percent.
With the ECB’s main interest rate already at a record low 0.25 percent, some analysts expect the central bank to start buying sovereign bonds to loosen monetary conditions.
”What really matters is deflation,“ said Hans Redeker, head of global currency strategy at Morgan Stanley. ”The euro is going to find it very difficult to hold its value.
“I think that with a ... fall in inflation and the development of deflation expectations the only credible instrument is outright QE (quantitative easing). It’s not the best tool, but there’s no other tool available.”
The common currency fell to 137.35 yen, facing the risk of settling below its 100-day moving average, now at 137.54, which some chartists regard as a bearish signal. It later recovered to 137.50 yen, down 0.1 percent on the day.
The dollar dropped to as low as 101.67 yen, its weakest since early December as investors remained wary of emerging economies and sought shelter in the Japanese currency.
A sharp sell-off in emerging currencies in recent days has supported the yen broadly.
With trading volumes still subdued after Friday’s Lunar New Year holiday in Asia, investors were looking to U.S. manufacturing purchasing managers’ data later on Monday for direction on the strength of the U.S. economy. Jobs data, which was unexpectedly weak last month, follows on Friday.
The U.S. PMI and payrolls data could signal the economy is growing fast enough for the Federal Reserve to keep cutting back its bond-buying programme - a move that could encourage investors to pull money from emerging markets and to put it into U.S. bonds.
“If the PMI is relatively strong, the possibility that will lead to a further eruption (in emerging markets) is quite high,” added Morgan Stanley’s Redeker, who expects dollar-yen to fall to 98 in the coming four weeks.
The dollar dropped against the Canadian dollar - which many hedge funds have been betting against - to a one-week low of C$1.1053.
Marshall Gittler, head of global FX strategy at IronFX Global, said the move was driven by money managers rebalancing the hedges in their portfolio at the end of the month.
“Given the technical nature of the move, I expect it will be only temporary and this pullback may represent a good opportunity to establish new short-CAD positions.”