June 6 (Bloomberg) -- The dollar fell to a one-week low against the euro after a government report showed the U.S. unemployment rate increased the most in more than two decades, adding to evidence the economy may not be rebounding.

The decline pushed the currency to its biggest two-day drop since March on speculation the Federal Reserve may refrain from raising borrowing costs this year. The dollar fell yesterday as European Central Bank President Jean-Claude Trichet said a July increase in the main refinancing rate, now twice the U.S. benchmark, is ``possible.'' Crude oil surged to a record.

``It's another blow to the dollar after Trichet's hawkish comments yesterday,'' said David Powell, currency strategist in New York at Bank of America Corp. ``The labor market is deteriorating. The interest-rate differential is moving in favor of the euro and against the dollar. We're going to retest $1.60 in the next few days.''

The dollar decreased 1.2 percent to $1.5774 per euro at 4:21 p.m. in New York, from $1.5593 yesterday, when it dropped 1 percent. It touched $1.5776, the weakest level since May 27, compared with the all-time low of $1.6019 reached April 22. The dollar dropped 0.9 percent to 104.98 yen, from 105.94. The euro increased 0.2 percent to 165.60 yen, after touching 166.16, the strongest since Dec. 28.

The U.S. currency fell 1.4 percent against the euro this week, its biggest decline since late March. It dropped 0.5 percent versus the yen. The euro posted a weekly increase of 0.9 percent against Japan's currency.

Stronger Yuan

The yuan rose the most in more than three months against the dollar today on speculation China will seek a stronger currency and a narrower trade surplus to help curb inflation. The currency increased 0.3 percent to 6.9231 against the dollar in Shanghai and has risen the same amount for the week.

The dollar extended its decline against the euro after the Radiocor news agency reported that ECB executive board member Lorenzo Bini Smaghi said in Venice that there's ``broad consensus'' that an interest rate increase may be necessary next month. ECB council member Axel Weber said in a speech in London that financial markets understand the central bank's anti- inflation message.

U.S. payrolls have shrunk every month this year, dropping 49,000 in May, the Labor Department reported today in Washington. The jobless rate increased to 5.5 percent from 5 percent, the biggest jump since February 1986.

``The big shock was the rise in the unemployment number,'' said Samarjit Shankar, director of global strategy for the foreign-exchange group in Boston at Bank of New York Mellon, the world's largest custodial bank, with about $23 trillion in assets under custody. ``It damps the outlook for a tightening in U.S. rates and strengthens the case for a run at $1.60.''

Trichet on Inflation

The U.S. currency dropped yesterday as Trichet said policy makers are in a state of ``heightened alertness'' over inflation. His remarks more than erased the dollar's gains that came after Fed Chairman Ben S. Bernanke said on June 3 that the central bank is ``attentive'' to the implications of the weakened currency.

Crude oil increased to a record $139.12 a barrel today as demand grew for a hedge against a weakened dollar. The U.S. currency has lost 11 percent against the euro since the Fed started to lower interest rates from 5.25 percent in mid- September, pushing prices of oil, gold and corn higher.

``The ECB has made a monumental error in their attempt to contain inflation,'' said Matthew Kassel, director of proprietary trading at ING Financial Markets LLC in New York. ``While this is a big buy-the-euro story now, it won't take long for this to reverse.''

Dollar Outlook

The dollar will strengthen to $1.50 against the euro and trade at 105 yen by the end of the year, according to the median forecast of 39 economists surveyed by Bloomberg.

Futures on the Chicago Board of Trade show a 64 percent chance the Fed will increase the target rate for overnight lending between banks by at least a quarter-percentage point by December, compared with 78 percent odds a week ago. The ECB yesterday kept its main refinancing rate at a six-year high of 4 percent, where it has been since last June.

The two-year U.S. Treasury note yielded 2.38 percent, or 2.25 percentage points less than the comparable-maturity German bund. The gap was the widest since 1993, making dollar- denominated assets less attractive.

``It's a battle between the shifts of the policies,'' said Adam Boyton, a senior currency strategist in New York at Deutsche Bank AG, the world's biggest currency trader. ``It's difficult to be a euro bear with a hawkish ECB.''

Turkey's lira fell to the lowest level in almost two weeks against the dollar after the nation's Constitutional Court ruled yesterday against a law backed by the ruling party allowing students to wear headscarves. The lira dropped 1 percent to 1.2426 per dollar, pushing its weekly decline to 2 percent. It's down 6 percent this year.

To contact the reporters on this story: Ye Xie in New York at yxie6@bloomberg.net; Bo Nielsen in New York at bnielsen4@bloomberg.net.

Last Updated: June 6, 2008 16:26 EDT