* Dollar near 1-month low vs yen, euro recovers from 2 1/2-yr low
* U.S. service sector slows to 3-year low
* U.S. payrolls data next big focus
* Graphic: World FX rates in 2019 tmsnrt.rs/2egbfVh
By Hideyuki Sano
TOKYO, Oct 4 (Reuters) - The dollar stepped back on Friday after a soft U.S. service sector survey inflamed worries that pressure from U.S. trade disputes with China and other countries could spill over into the broader U.S. economy and eventually tip it into a recession.
The dollar index fell to 98.816, shedding about 0.9% after hitting a 2-1/2-year high this week. It is down 0.3% on the week.
Against the yen, the U.S. currency eased to 106.78 yen , down 0.15% and having fallen to one-month low of 106.48 in U.S. trade on Thursday.
The euro, which had been dogged by concerns Germany could slip into a recession, rose 0.15% to $1.0980, extending its recovery from a near 2-1/2-year low of $1.0879 set on Tuesday.
The common currency has gained 0.34% so far on the week.
A survey from the U.S. Institute for Supply Management (ISM) showed its non-manufacturing activity index falling to 52.6 in September, the lowest since August 2016, and far below expectations of 55.1, from 56.4 in August.
Coming on the heels of a similar survey on Tuesday on manufacturing showing activity plunging to a more than 10-year lows, the weak data increased fears of a U.S. recession.
The U.S. service sector, backed by firm U.S. domestic consumption, has been one of few bright spots in the global economy as the manufacturing sector worldwide has been knocked by the protracted U.S-China trade war.
“People have been saying that U.S. domestic demand will remain strong even as its external demand weakens. But as time passes by, U.S. consumption will be inevitably affected by what’s happening outside. Companies are getting more cautious about hiring and spending,” said Minori Uchida, chief currency strategist at MUFG Bank.
A gauge of employment in the ISM survey in fact fell to 50.4 last month, the lowest reading since February 2014, from 53.1 in August.
That does not bode well for the upcoming all-important U.S. jobs data on Friday, said Daisuke Uno, chief strategist at Sumitomo Mitsui Bank, noting the employment component in the ISM has had a meaningful correlation with the payrolls data.
“It is reasonable to think the non-farm payrolls figure is more likely than not to come on the disappointing side. It could even fall below zero,” he said.
The median economists’ forecast polled by Reuters is for a rise of 145,000 in September, a tad below the average over the last 12 months around 173,000.
Heightened worries about the U.S. service sector increased expectations that the U.S. Federal Reserve will cut interest rates at the end of this month, undermining the dollar’s yield advantage.
Fed funds rate futures are almost fully pricing in a 25 basis point rate cut at Oct. 30 and a high chance of another cut by December.
But some market players think rate cuts are far from a done deal.
“Opinions in markets over whether the Fed needs to cut rates that much are divided. The dollar is not going to fall sharply given not everyone thinks the Fed will cut rates this month,” said Kazushige Kaida, forex manager at State Street.
Elsewhere, sterling traded at $1.2333, up 0.2% on the day.
It has risen to one-week high of $1.2413 on Thursday after the head of a group of eurosceptic lawmakers in Prime Minister Boris Johnson’s Conservative Party said the government’s latest Brexit proposals offered the possibility of a “tolerable deal.”
Still, traders remained unsure whether Johnson’s proposal to replace the Irish border “backstop” was going to morph into a final Brexit divorce agreement due to mixed messages coming from both sides. (Reporting by Hideyuki Sano; Editing by Gerry Doyle & Shri Navaratnam)