| NEW YORK
NEW YORK The U.S. dollar fell to a three-week low against the euro on Thursday after unexpectedly weak U.S. economic data cooled expectations that the Federal Reserve will reduce its monetary stimulus soon.
Speculation that the Fed could start the process by tapering its $85 billion in monthly purchases of U.S. Treasuries and housing agency debt as early as the summer had fueled a strong rally in the dollar. It pushed futures positioning to extended levels, leaving the currency vulnerable to a reversal, traders said.
The U.S. economy grew at a slightly slower pace in the first quarter than initially estimated, according to data released on Thursday. Separate reports showed weekly initial jobless claims unexpectedly rose last week and pending home sales increased less than expected.
Analysts said the weaker data could reinforce expectations that the economy still needs a lot of monetary stimulus. Fed Chairman Ben Bernanke said this month that the U.S. central bank could "in the next few meetings take a step down," but only if economic improvement continued.
The Fed has promised to keep its benchmark interest rates near zero until the U.S. unemployment rate falls to 6.5 percent or so. The rate in April was 7.5 percent.
"We need two things, according to Bernanke, to consider tapering. That is, we need stronger data, and we need more confidence of sustained improvement. And today's data simply does not support that conclusion," said Michael Woolfolk, senior currency strategist at BNY Mellon in New York.
"Don't bet on higher rates just yet from the U.S. I think that view is helping to support stocks and bonds, while at the same time undermining the dollar," he said.
The euro rose 0.83 percent to $1.3046, after reaching a session peak of $1.3061, according to Reuters data, the strongest since May 9.
Against the yen, the dollar slipped 0.44 percent to 100.69 yen, retreating from a session peak of 101.80 yen.
The yen had come under pressure after sources familiar with the deliberations told Reuters that Japan's Government Pension Investment Fund (GPIF) was considering a more flexible approach to allocations, which could let investment in domestic stocks grow in rallying markets.
Traders said the news pushed Nikkei equity futures higher and caused yen selling. In recent months, Japan's stock market and the yen have shown a negative correlation. The yen, seen as a safe haven, tends to benefit in times of market stress.
Foreign investors' buying of Japanese equities has also contributed to yen weakness as they hedge currency exposure by selling the yen.
"The rationale behind the yen selling on the back of Japan's GPIF headlines seems linked to the hedging behavior of foreign investors buying Japanese stocks," said Valentin Marinov, head of European G10 FX strategy at Citi, in London.
"If the headline is confirmed, it could fuel a renewed Nikkei rally and hence more demand for short-yen hedges by foreign investors. This could trigger more dollar/yen buying from here."
Most market participants expect the dollar to continue to gain against the yen over the medium term on expectations of further easing by the Bank of Japan.
The euro rose 0.36 percent to 131.36 yen.
Adding to the euro's strength was data showing confidence in the euro-zone economy grew more than expected in May.
Against a basket of currencies, the dollar index .DXY lost 0.79 percent to 82.994, after falling to a two-week low of 82.979.
Despite the latest dollar weakness, Jens Nordvig, global head of FX strategy at Nomura Securities in New York, said he expects the dollar to strengthen meaningfully versus major currencies in the next six to nine months.
"The dollar has entered a new regime. We are observing a 'bull dollar rally' - a dollar-strengthening trend which is happening in tandem with strong performance of risky assets and increasing optimism about U.S. growth," he wrote to clients.
(Additional reporting by Daniel Bases in New York and Anooja Debnath in London; Editing by James Dalgleish, Nick Zieminski and Jan Paschal)