Oct. 8 (Bloomberg) -- The dollar declined the most against the euro in more than two weeks as global central banks made coordinated reductions in borrowing costs, reducing demand for the U.S. currency as a haven from credit market turmoil.

The euro pared its loss against the yen as the interest- rate cuts encouraged investors to buy higher-yielding assets funded by low-cost loans in Japan. The dollar rose to a 14-month high versus the euro on Oct. 6 as the financial crisis spurred a surge in demand for U.S. currency funding in money markets.

``A major dollar funding squeeze has supported the dollar dramatically,'' said Jens Nordvig, a senior currency strategist in New York at Goldman Sachs Group Inc. ``What this might do is reduce the funding squeeze and lead to some retracement of recent dollar strength.''

The dollar dropped 0.6 percent to $1.3666 per euro at 4:17 p.m. in New York, from $1.3588 yesterday. It touched $1.3444 on Oct. 6, the strongest since August 2007, when the credit market crisis gathered momentum. The euro declined 1.1 percent to 136.39 yen from 137.89 after touching 134.17, the lowest level since August 2005. The dollar fell 1.6 percent to 99.83 yen from 101.47 after reaching 98.61, the weakest since March 27.

The Federal Reserve reduced its target lending rate by a half-percentage point to 1.5 percent, while the European Central Bank and counterparts of the U.K., Canada, Sweden and Switzerland also reduced rates. Separately, China's central bank lowered its key one-year lending rate.

Iceland Scraps Peg

Iceland ditched a peg equivalent to 131 krona per euro after failing to convince investors it could maintain such a defense of the currency. The government canceled the purchase of a 75 percent stake in Glitnir Bank hf and handed the troubled lender over to regulators.

The yen pared its gain versus Brazil's real on speculation the rate cuts will boost carry trades, in which investors get funds in a country with low borrowing costs and buy assets where returns are higher. Japan's currency increased 1.8 percent to 44.02 per real after earlier surging as much 10.7 percent.

The Bank of Japan's 0.5 percent target lending rate compares with 13.75 percent in Brazil and 5.75 percent in Norway. The Reserve Bank of Australia cut its cash rate by 1 percentage point to 6 percent yesterday.

Traders priced in wider price fluctuation in major currencies for the coming month. Implied volatility on one-month euro-dollar options reached 20.1 percent, the highest since the euro's 1999 debut. The gauge for one-month dollar-yen options soared to 26.4 percent, the highest since October 1998. Higher volatility tends to discourage carry trades by making profit from interest-rate spreads less predictable.

U.S. Stocks

The Standard & Poor's 500 Index fell 1.1 percent after earlier slumping as much as 2.5 percent. The Dow Jones Industrial Average dropped 2 percent.

Mexico's peso rose 1.1 percent to 12.1790 against the dollar after the central bank said it would auction greenbacks to prop up the local currency. The peso earlier declined as much as 16.1 percent to 14.2927, the weakest level since the government introduced a new peso equivalent to 1,000 old pesos in 1993 following years of runaway inflation.

The International Monetary Fund cut its growth forecast for the world's advanced economies next year to the slowest pace since 1982. Industrial economies will grow 0.5 percent in 2009, down from 1.5 percent this year, the Washington-based fund said in its World Economic Outlook today.

ECB President Jean-Claude Trichet said in an interview on Bloomberg Television that today's half-percentage point reduction in the main refinancing rate to 3.75 percent is ``no particular signal'' of whether more cuts are needed.

Global Rate Cuts

Canada's target lending rate was cut to 2.5 percent; the Bank of England's rate dropped to 4.5 percent; and Sweden's declined to 4.25 percent. Separately, China lowered interest rates for the second time in three weeks, reducing the main rate to 6.93 percent.

Finance ministers and central bankers from the Group of Seven nations will meet in Washington on Oct. 10 to discuss the financial crisis. The G-7 comprises Canada, France, Germany, Italy, Japan, the U.K. and the U.S.

The dollar has gained more than 6 percent versus the euro since the beginning of September partly because the financial crisis has spurred a surge in demand for U.S. currency funding in global money markets.

``We think we could be at a tipping point right now where demand for the dollar is beginning to subside,'' said Robert Sinche, head of global currency strategy at Bank of America Corp. in New York, in an interview on Bloomberg Radio. The dollar may ``give up a lot of its gains'' once the ``extreme tension'' in short-term funding eases, he said.

To contact the reporter on this story: Ye Xie in New York at yxie6@bloomberg.net

Last Updated: October 8, 2008 16:18 EDT