Sept. 21 (Bloomberg) -- The dollar fell the most since July versus the euro and yen after a report showed manufacturing in the Philadelphia area unexpectedly shrank this month.

The U.S. currency extended earlier declines as the statistics led traders to erase bets on another interest-rate increase by the Federal Reserve this year. The Fed yesterday kept its overnight lending rate between banks at 5.25 percent for a second month and said inflation will cool.

``It is consistent with soft economic growth in the U.S.,'' said Matthew Kassel, director of proprietary trading at ING Financial Markets LLC in New York. ``When the Fed is done raising interest rates, the dollar will be sold off dramatically.''

The dollar weakened to $1.2780 per euro at 5:03 p.m. in New York from $1.2686 late yesterday, for its biggest loss since July 26. The U.S. currency fell to 116.35 yen from 117.46 yesterday, the largest decline since July 28.

The Fed Bank of Philadelphia said today its index for September fell to -0.4 from 18.5 in August. The median forecast in a Bloomberg survey was for a drop to 14. Readings above zero signal growth.

Interest-rate futures show traders have erased expectations for another Fed increase and are starting to bet on a rate cut. A month ago, futures showed traders still saw a 50 percent chance the Fed would raise its benchmark to 5.5 percent by year-end. The Fed next meets to set rates on Oct. 24-25, and then in December.

`Significant Dollar Selling'

The yield on the December Fed funds futures dropped to 5.23 percent following the Philly Fed report, the lowest since June and below the Fed's benchmark, which indicates traders are starting to price in a possible rate cut that month.

``The Fed is definitely done hiking rates,'' said Alan Kabbani, a senior currency trader at Wachovia Corp. in Charlotte, North Carolina. ``People are going to adjust their expectation as the U.S. economy continues to slow down. The dollar bullishness is over.''

Kabbani predicted the dollar will fall to $1.3450 per euro and 108.50 yen by the end of this year.

U.S. 10-year Treasury notes yielded 0.89 percentage point above similar-maturity German government debt, the least since July 2005.

The U.S. currency has lost 7.4 percent against the euro and 1.2 percent versus the yen this year on speculation central banks in Europe and Japan will outpace the Fed in raising borrowing costs. The U.S. central bank paused last month after raising rates at 17 straight meetings since June 2004.

`Fed is Done'

The Conference Board said its index of leading indicators dropped 0.2 percent last month after a 0.2 percent decline in July, suggesting the economy's slowdown will extend into next year.

``The market is thinking that the Fed is done,'' said Steven Englander, head of currency strategy for the 10 major industrialized nations at Merrill Lynch & Co. in New York. ``The U.S. economy is showing more concrete evidence of a slowdown; it is dollar-negative.''

Englander said the dollar will weaken to $1.34 per euro and 107 yen by year-end.

The yen also advanced on speculation China will allow faster gains in the yuan as U.S. Treasury Secretary Henry Paulson, who favors a more flexible Chinese currency, meets China's Finance Minister Jin Renqing today in Beijing.

Yuan Gains

The yuan today reached its strongest since China ended the currency's peg to the dollar in July last year. The yuan rose 0.04 percent to 7.9233 per dollar, for a 2.4 percent gain since July 2005, according to Bloomberg data.

``It does appear that they are allowing greater flexibility in exchange rates,'' said Robert Sinche, head of global currency strategy at Bank of America Corp. in New York. ``They are making progress.''

China limits daily moves in the yuan. A stronger yuan may make it cheaper for China's consumers to buy Japanese goods and increase the cost of China's exports.

European Central Bank council member Axel Weber said today in a speech in Beijing that countries running current account surpluses would benefit from more flexible exchange rates. China's trade surplus reached a record $18.8 billion in August.

The Senate is likely to pass within the next week a measure to put tariffs on imports from China in retaliation for that country's currency policies, Republican Charles Grassley said today.

Grassley, who voted against the measure sponsored by Democrat Charles Schumer and Republican Lindsey Graham last year, said China's unwillingness to revalue its currency makes it likely the tariff legislation would get support.

Asian currencies also rose on signs a coup this week in Thailand won't prompt investors to sell assets in the region. Army chief Sondhi Boonyarataklin took power without bloodshed and pledged to hold elections in October 2007.

The Thai baht gained 0.4 percent to 37.53 per dollar today, rebounding from the biggest loss in almost three years on the day of the coup.

``It is an isolated event related very much to local politics,'' said Sinche.

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

Last Updated: September 21, 2006 17:05 EDT