Aug. 7 (Bloomberg) -- The dollar may weaken on speculation the Federal Reserve tomorrow will halt a two-year campaign of increasing borrowing costs as the U.S. economy shows more evidence of slowing growth.

The U.S. currency may fall for a third day against the euro and a second versus the yen on speculation the Fed will hold its overnight lending rate between banks at 5.25 percent. Investors will seek rising yields in Europe and Japan, Pacific Investment Management Co., which runs the world's biggest bond fund, said in its latest market outlook report on its Web site.

``The Fed will be unable to raise rates tomorrow amid signs of a slowing economy,'' said Masaki Fukui, an economist and currency analyst in Tokyo at Mizuho Corporate Bank Ltd., a unit of Japan's second largest lender by assets. ``The dollar- bearish trend is likely to accelerate as the Fed already may be done.''

The dollar bought 114.57 yen at 7:23 a.m. in London from 114.44 in late New York trading on Aug. 4. Against the euro, the dollar was at $1.2882 from $1.2873. It may fall to 110 yen and $1.31 per euro by year-end, Fukui said.

Bill Gross, who manages the record $93 billion Total Return Fund, in an interview Aug. 4 said a sliding U.S. currency may erode overseas demand for long-term U.S. Treasuries.

``Pimco will likely take positions in the yen, emerging- market currencies and the euro to hedge against dollar weakness,'' said the report, which didn't give forecasts.

The U.S. currency dropped to a two-month low against the euro and a three-week low versus the yen on Aug. 4 after a report showed the U.S. economy added fewer jobs than expected.

U.S. employers added 113,000 jobs last month after an increase of 124,000 in June, less than the 144,000 median forecast in a Bloomberg News survey.

Declining Odds

A Labor Department report tomorrow may signal worker productivity slowed to below 3.5 percent last quarter, the average rate during an expansion that began in November 2001.

Productivity, which measures how much an employee produces for every hour worked, rose at an annual rate of 0.8 percent, after a 3.7 percent pace in the first quarter, according to the median estimate of 55 economists in a Bloomberg News survey.

The dollar has fallen as signs of a slowdown in U.S. economic growth raised speculation the Fed won't add to 17 rate increases since June 2004.

Interest-rate futures showed traders see 18 percent odds the Fed tomorrow will lift its overnight lending rate between banks by a quarter-percentage point to 5.50 percent, down from 31 percent on July 31 and 85 percent on June 26.

Sixty-one percent of 46 traders, strategists and investors surveyed by Bloomberg on Aug. 4 from Sydney to New York advised selling the dollar against the euro this week. Fifty-four percent of those surveyed said sell the currency versus the yen.

Rate Disadvantage

Gains in the yen may be limited by speculation the Bank of Japan will raise rates at a gradual pace and the Fed will resume lifting borrowing costs, retaining the yield advantage of assets denominated in the dollar.

Japan's central bank last month boosted rates for the first time in almost six years, forecasting sustained growth and an end to deflation. Governor Toshihiko Fukui and Deputy Governor Toshiro Muto have since said the bank will keep rates ``very low'' for some time and adjust them gradually.

The differential between benchmark 10-year U.S. and Japanese debt was 3.07 percentage points today, above the average of 3.01 percentage points during the past year.

``Even though the Fed pauses tomorrow, Japan's absolute interest-rate disadvantage still prevails,'' said Koichi Yoshikawa, head of foreign-exchange trading at BNP Paribas in Tokyo. ``This will weigh on the yen,'' which may move between 113 and 118 per dollar in one month.

`Can't Be Denied'

The euro may be supported by speculation the European Central Bank will keep pushing up interest rates.

The ECB will continue to raise rates as economic growth accelerates, Lorenzo Bini Smaghi, an ECB executive board member, said yesterday in an interview with Il Sole/24 Ore.

Even following an increase on Aug. 3, ``it can't be denied'' that rates are ``still very accommodating,'' the newspaper cited Bini Smaghi as saying. ``The process of realigning interest rates will continue in coming months.''

The ECB Aug. 3 lifted its benchmark by 0.25 percentage point to 3 percent. Europe's economy may expand faster than the initial forecast of 2.1 percent for the full year, the fastest pace since 2000, the European Commission said July 11.

``The euro is currently well supported by heightened expectations for further ECB rate increases,'' said Takehiko Jimbo, a currency manager in Tokyo at Mitsubishi UFJ Trust & Banking Co., a unit of Japan's biggest lender by assets. ``This is quite a contrast to speculation the Fed will pause.''

The euro may rise to $1.31 against the dollar and 148 yen this week, Jimbo said.

To contact the reporter on this story: Chris Young in Sydney at cyoung12@bloomberg.net; Ron Harui in Singapore at rharui@bloomberg.net

Last Updated: August 7, 2006 02:25 EDT