Sept. 11 (Bloomberg) -- The dollar rose to the highest level in a year against the euro on speculation that economic growth in Europe will be slower than in the U.S., prompting the region's central bank to lower interest rates.

The U.S. currency climbed for a second day as traders raised bets that the European Central Bank will cut borrowing costs before a government report tomorrow likely to show industrial production in the euro area shrank. New Zealand's dollar dropped to its lowest level since October 2006 after Alan Bollard, governor of the nation's central bank, reduced interest rates by more than economists expected.

``We've got this dollar strength for several weeks now that is driving currency markets and the fundamental picture is underpinning this,'' said Lutz Karpowitz, a currency strategist in Frankfurt at Commerzbank AG, Germany's second-biggest lender. ``The euro-zone economy is going into recession. This is a growth-differential story.''

The U.S. currency climbed to $1.3893 per euro, the strongest since Sept. 18, 2007, before trading at $1.3949 as of 7:14 a.m. in New York, from $1.3998 yesterday. The Japanese yen advanced to 148.38 per euro, the highest since Nov. 2, 2006, and was last at 149.01, from 150.75. It also gained to 106.83 per dollar from 107.70.

The dollar will rise in coming days to $1.3830 against the euro, a so-called resistance level that may trigger orders to sell the U.S. currency, Karpowitz said.

ECB Versus Fed

The ECB will cut its main refinancing rate a quarter point to 4 percent in the first three months of next year, while the Federal Reserve raises its target rate for overnight bank loans by the same amount to 2.25 percent, according to Bloomberg surveys of economists.

The diverging interest-rate outlook narrowed the so-called yield spread between German and U.S. two-year government notes today. The spread was 1.81 percentage points, down from 1.88 percentage point a week ago.

The ICE's Dollar Index touched 80.375 today, the highest since September 2007, when the U.S. central bank began cutting its target rate from 5.25 percent to 2 percent to stave off a recession. The index, a gauge measuring the dollar against the currencies of six U.S. trading partners, reached a low of 70.698 on March 17. It was last at 80.115.

The European Commission said yesterday the euro region's economy will probably stagnate this quarter after shrinking the previous three months for the first time since the currency's debut in 1999. It cut its 2008 growth forecast to 1.3 percent, from 1.7 percent. By contrast, the median in a Bloomberg News survey of 84 economists was for U.S. growth of 1.7 percent.

New Zealand Dollar

The New Zealand dollar declined to as low as 64.38 U.S. cents before trading at 64.80 cents, down 2.1 percent from yesterday. Against the yen, it declined to 69.21, from 71.38, the biggest drop since March 17. The Reserve Bank of New Zealand cut its benchmark interest rate by half a percentage point to 7.5 percent, saying the economy is in a recession.

The yen rose against all 16 of the most-active currencies on speculation that widening subprime-mortgage losses will hurt earnings of U.S. companies, reducing demand for so-called carry trades.

In carry trades, investors get funds in a country with low borrowing costs and buy assets where returns are higher. Japan's target lending rate is 0.5 percent, compared with 7 percent in Australia. The risk is that currency swings erase profits.

``Investors in Japan are in risk-aversion mode, so they're buying the yen,'' said Ryohei Muramatsu, manager of Group Treasury Asia in Tokyo at Commerzbank AG. ``The economy also is doing poorly'' so the yen may appreciate to 107.00 against the dollar today.

Implied Volatility

The currency gained for a fourth day against the euro after implied volatility on one-month euro options versus the yen rose to 16.94 percent, the highest since March 18.

The yen stayed higher after a government report showed Japanese machinery orders fell for a second month in July, signaling manufacturers expect the global slowdown to crimp demand into next year.

The Australian dollar dropped to the lowest since August 2007 today as prices tumbled for raw materials, which account for about 60 percent of the nation's exports. It reached a low of 79.01 cents, form 80.13 cents yesterday. It fell 2.2 percent against the yen, to 84.44.

Shipping Measure

The currency will extend its 19 percent drop from a 25-year high, judging by a plunge in the costs to ship coal and iron ore, the nation's biggest export earners, according to Stephen Koukoulas, London-based head of global foreign-exchange and fixed-income strategy for TD, a division of Canada's Toronto- Dominion Bank.

The currency will slide 2.6 percent to 78 U.S. cents by year-end because a slump in the Baltic Dry Index, a measure of shipping costs for commodities, signals demand for the raw materials Australia exports is waning, said Koukoulas.

The European Union's statistics office in Luxembourg will probably say tomorrow that industrial output in the 15 nations fell 0.2 percent in July after a revised 0.2 percent decline in June, according to a Bloomberg News survey of economists.

``The euro is likely to extend its adjustment lower,'' said Saburo Matsumoto, senior manager of foreign-exchange sales in Tokyo at Sumitomo Trust & Banking Co., Japan's fifth-largest publicly traded bank by market value. ``The euro-zone economy is facing a recession, so a weaker currency could provide some relief to exports.''

Europe's single currency may weaken to 147.50 yen in the next few days, Matsumoto forecast.

Implied volatility on the dollar versus the most actively traded currencies was at 11.55 percent after touching 12 percent, the highest since April, according to the JPMorgan Volatility index. The gauge of perceived price fluctuation in the dollar reached 9.27 percent on Aug. 4, the lowest this year.

To contact the reporters on this story: Agnes Lovasz in London at alovasz@bloomberg.net; Ron Harui in Singapore at rharui@bloomberg.net

Last Updated: September 11, 2008 07:24 EDT