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By Carolyn Cohn
LONDON - The dollar headed back toward three-year lows on the euro on Wednesday as the market resigned itself to a likely U.S.-led conflict with Iraq after a hawkish speech from President Bush.
Signs of a weak Wall Street later also weighed on the dollar, which failed to sustain a recovery in the previous session after Bush vowed in his State of the Union address to use the full force of the U.S. military to disarm Baghdad.
"When you go through the speech it looks like he's beating the war drum even harder now. People are more and more resigned to the fact that war is on the horizon and that's a dollar-negative scenario," said Paul Mackel, currency strategist at Dresdner Kleinwort Wasserstein.
The U.S. Federal Reserve ends its two-day policy meeting later on Wednesday and while no one expects the central bank to lower interest rates, some say it could shift its assessment of risks facing the economy to say there is a danger of weakness.
"Apart from what's going on with Iraq, there has to be some attention directed to the U.S. economy -- and it's struggling. That can't do much for foreign investors wanting to shift a lot of money into U.S. corporate assets," Mackel said.
By 5:45 a.m. EST the dollar was half a percent down on the day against the euro at $1.0877, a little above earlier lows of $1.0899 and close to a three-year low set on Monday at $1.0907.
Traders said talk of an option barrier at $1.0930 was likely to keep euro gains in check.
Germany, the euro zone's largest economy, cut its 2003 growth forecast to one percent from 1.5 percent, as expected.
Against the safe-haven Swiss franc, the dollar was also half a percent down on the day and just half a centime away from a recent four-year low near 1.3450.
It dipped nearly half a percent on the yen to 118.12 and was a third of a percent lower against the pound, a little above earlier three-year lows of $1.6487.
U.S. STOCK DOLDRUMS
U.S. stock futures were pointing to a sharply lower start on Wall Street later after gains of more than one percent for major indices on Tuesday.
Bush's speech came in the early hours of Wednesday morning, after U.S. trading was over, and he made it clear the United States is prepared to act to disarm Iraq with or without U.N. backing.
In an attempt to convince doubting allies, he called on the U.N. Security Council to convene on February 5 to hear Secretary of State Colin Powell present further information about Iraq's suspected programs on weapons of mass destruction.
Players are now looking ahead to Bush's meeting with British Prime Minister Tony Blair on Friday at Camp David to see if any time frame for an attack will be discussed.
"The markets are now fully pricing in the increasing risks of war," said Ian Stannard, currency strategist at BNP Paribas.
U.S. Treasury Secretary nominee John Snow reiterated the long-standing U.S. strong dollar policy in his confirmation hearing to a congressional committee on Tuesday.
"Snow's comments were in the context of an 18 percent fall in the dollar (in the past year)," said Stannard.
"It seems that as long as there is no dollar crisis, a slow and steady depreciation in the dollar is not going to attract any commentary from the U.S. administration."
YEN OUT OF FASHION
While retaining strength against the dollar, the Japanese currency was sold against its European counterparts, although by the European midsession it had recovered to stand virtually unchanged on the day at 128.54 per euro, half a yen above a recent 3-1/2 year low.
Dealers noted growing demand for the euro, the pound and the Australian dollar from Japanese retail investors who are fed up with the extremely low interest rates in Japan.
The yield on the key 10-year Japanese government bond fell to a historical low of 0.770 percent on Wednesday.
"There has been constant buying of the euro, the pound and the Aussie dollar by Japanese individuals recently," said Kota Kimura, an assistant manager at Shinkin Central Bank in Tokyo.
"Interest rates are falling worldwide, but outside rates are still much higher than Japanese rates," he said.
Japanese Prime Minister Junichiro Koizumi said in early European trade on Wednesday that weakness in Tokyo share prices was caused in part by a strong yen.
Koizumi also said a fall in the long-term yields of Japanese government bonds reflected both Japan's deflationary conditions and a lack of other attractive assets to invest in.