Euro hits six-week low as European bank repayments disappoint

NEW YORK (Reuters) - The euro dropped to a six-week low against the dollar on Friday after the European Central Bank announced crisis loan repayments by banks that were far below what markets had expected, casting doubts on the health of the euro zone's financial system.

The ECB said banks will repay 61.1 billion euros of the second of two crisis ECB three-year loans they took a year ago, far below the 130 billion euros in repayments expected by the market.

"The low repayment ... will keep liquidity conditions accommodative for the time being in the euro zone," said Nick Bennenbroek, head of currency strategy at Wells Fargo Bank in New York.

The data signaled that some banks still feel the need to keep hold of the ultra-cheap emergency loans and means the ECB's balance sheet will shrink at a slower pace.

Richard McGuire, senior fixed income strategist at Rabobank, said that Italian banks may have held off repaying the loan due to the uncertainty about the result of the Italian election this weekend.

Analysts are divided over whether center-left leader Pier Luigi Bersani will be able to form a stable majority capable of pursuing the economic reforms that an uncompetitive Italy needs to exit recession.

A report from the European Commission on Friday that forecast the euro zone economy will contract again in 2013 also weighed on the euro, which fell for a third straight session.

The euro fell as low as $1.3144, its lowest since January 10, retreating from a session high of $1.3244 after the German Ifo survey showed a big jump in business morale in Germany, suggesting a brighter outlook for the euro zone's largest economy.

The euro was last down 0.2 percent at $1.3167, with market players reporting supporting bids around $1.3150-60.

Europe's common currency was on pace to close lower for a third straight week.

The euro has come under heavy pressure against the dollar since minutes of the U.S. Federal Reserve's latest meeting that were released on Wednesday fueled speculation the Fed may start to tighten monetary policy earlier than markets have expected.

Some strategists said they expect the euro to grind lower ahead of the Italian elections, although it should find support around $1.3040, near the January 10 low of $1.3037.

Investors were wary about the risk of a fragmented Italian parliament or resurgence by former Prime Minister Silvio Berlusconi, which could hinder the euro zone's third largest economy from fighting its longest recession in 20 years.

Market participants in general are taking a more defensive position -- betting on the euro's downside -- in case of an adverse outcome in Italy. The result of the two-day Italian vote is not expected until next week.

Bob Lynch, chief currency strategist at HSBC in New York said he continues to expect a weaker euro due to a host of technical factors.

"The downward shift in momentum indicators, the break below the July 2012 uptrend, and the further shift in relative yield spreads against the euro suggest to us that the risks remain on the downside in the near-term," said Lynch.

YEN WEAKNESS

The euro and the dollar rose against the yen, although strategists said the Japanese currency's three-month decline was showing signs of losing momentum.

Expectations the new Japanese government will take aggressive easing steps in an attempt to revive the economy have helped the yen fall steeply across the board since November.

The dollar rose 0.3 percent on the day to 93.34 yen, keeping some distance from a 33-month high of 94.47 hit last week. The euro edged up 0.1 percent to 122.90 yen.

Some market players said the fact U.S. policymakers had not particularly objected to yen weakness, which makes Japan's exports more competitive relative to those of other countries, meant the downtrend could continue.

"We didn't really realize how aggressive the Japanese officials would get, and we also didn't really sense the U.S. condoning it as much as they did," said John Vail, chief global strategist at Nikko Asset Management.

"It could be that they are quite willing to let the yen get to this level. My sense is that the 95-105 yen level is the intended range."

The Australian dollar regained ground after falling to a four-month low of US$1.0221 against a broadly stronger U.S. currency on Thursday. The Aussie rose 0.7 percent to US$1.0315.

(Additional reporting by Nia Williams in London; Editing by Leslie Adler)