Dec. 2 (Bloomberg) -- The dollar tumbled for a second consecutive week, dropping to the lowest level against the euro since March 2005, after declines in manufacturing and consumer confidence raised speculation the Federal Reserve will cut borrowing costs early next year.

The U.S. currency also slumped to a 14-year low versus the British pound and weakened against the Japanese yen. The yield premium on U.S. Treasuries over German debt shrank to the smallest in 17 months. Lower interest rates make a currency less attractive to investors because they provide a smaller return.

``The U.S. economy continues to soften,'' said Brian Garvey, senior currency strategist in Boston with State Street Global Markets, the custodian of $10.7 trillion of assets. The ``interest-rate differential is collapsing for the dollar. You are going to see the dollar remain on the downside.''

The dollar dropped 1.8 percent to $1.3331 per euro. It touched $1.3348 yesterday, the lowest since March 2005. The U.S. currency also fell 0.5 percent to 115.33 yen and sank to a three- month low of 114.98. The dollar slid 2.5 percent versus the British pound, its biggest weekly loss since January and weakened to as low as $1.9848, the lowest since September 1992.

The U.S. currency has declined 3.9 percent in the past two weeks, its biggest two-week drop since April 14-28 after G-7 ministers raised concerns about U.S. structural balances and suggested Asian currencies needed to gain against the dollar.

Contraction

The Institution for Supply Management said yesterday its factory index fell to 49.5 in November from 51.2 a month earlier. The report followed the National Association of Purchasing Management-Chicago a day earlier which said its business barometer fell to 49.9 this month from 53.5 in October. A reading below 50 signals contraction.

``The ISM is providing icing to the cake for dollar bears,'' said Alan Ruskin, head of international currency strategy in North America at RBS Greenwich Capital Markets Inc. in Greenwich, Connecticut. ``The market is shifting gear to dollar weakness.''

An index of U.S. consumer confidence unexpectedly dropped to 102.9 this month from 105.1 last month, the Conference Board said Nov. 28. Economists expected an increase to 106, a Bloomberg survey showed.

Futures contracts suggested yesterday traders see about a 100 percent chance of a cut to 5 percent in March, up from 73 percent before the ISM report.

Risk

The Fed left its benchmark rate at 5.25 percent in the past three months, after two years of increases. The yield premium on U.S. 10-year notes over German debt narrowed to 76 basis points yesterday, the smallest since June 2005.

``The risk of a Fed rate cut in the first quarter is increasing,'' said Matthew Strauss, senior currency strategist at RBC Capital Markets Inc. in Toronto, a unit of Canada's biggest bank by assets. ``It adds to the negative trend in the dollar.''

The dollar dropped even as Fed officials, including Chairman Ben S. Bernanke, continued to signal that inflation remains a risk. Federal Reserve Bank of Chicago President Michael Moskow said yesterday higher interest rates may still be needed to bring down inflation.

A price gauge tied to spending and excluding food and energy costs rose 2.4 percent from a year earlier, the same pace as September, the Commerce Department said Nov. 3. The median forecast in a Bloomberg survey was for it to slow to 2.3 percent.

`Hawkish Tone'

Fed officials including Bernanke have said they are more comfortable with inflation between 1 to 2 percent.

``The data supported the hawkish tone from Fed,'' said Samarjit Shankar, director of global strategy for the foreign exchange group in Boston at Mellon Financial Corp. ``I don't think they will pull the trigger for a rate cut any time soon.''

The euro region's economy will start 2007 stronger than anticipated, the European Commission said Nov. 30. The forecast reinforced speculation the European Central Bank will continue raising interest rates into next year.

The ECB will raise rates for the sixth time in a year, to 3.5 percent on Dec. 7, according to the median estimate of economists in a Bloomberg News survey.

The yen dropped to a record low against the euro yesterday after a government report showed inflation unexpectedly slowed in October. Core consumer prices excluding fresh food rose 0.1 percent from a year earlier, slower than the 0.2 percent median forecast of economists in a Bloomberg survey.

The yen declined 1.36 percent against the euro to 153.76 and touched a record low of 154.11. It is the biggest weekly slump since the week ended Jan. 27.

To contact the reporter on this story: Min Zeng in New York at mzeng2@bloomberg.net.

Last Updated: December 2, 2006 08:55 EST