(Updates prices, adds reference to Lacker, data)
By Steven C. Johnson
NEW YORK, Dec 19 (Reuters) - The dollar rose against the euro and surged to a three-month peak against sterling on Wednesday amid signs that financial market turmoil was starting to threaten economic growth beyond U.S. borders.
The euro was hit after an index of German business sentiment came in close to a one-year low, prompting investors to increase year-end dollar buying.
Large institutional investors also helped pushed sterling below the $2 threshold for the first time since September, with traders pricing in another interest rate cut after minutes from the Bank of England's last meeting this month showed unanimous support for a cut to 5.5 percent.
"A tremendous amount of subprime mortgage debt was bought by British and European banks, and while the subprime crisis was U.S.-made, its effects are global. I think markets are realizing that," said Boris Schlossberg, senior currency strategist at DailyFX.com in New York.
Volumes were typically light ahead of year-end and traders said that exaggerated some of the price action.
In late trading, the euro was 0.2 percent weaker at $1.4382 <EUR=>. Earlier it fell as low as $1.4327. Sterling hit a three-month low at $1.9930 before recovering to $1.9975 <GBP=>, still down 0.8 percent from late Tuesday.
Strong demand for the Federal Reserve's $20 billion auction of $20 billion in 28-day loans, part of a coordinated effort by major central banks to ease a credit crunch in the money markets, saw the dollar trim losses against the yen.
The dollar last traded at 113.36 yen <JPY=>, unchanged on the day, after dipping below 113.
"The (auction) news was very mild, nothing too positive or too negative. There seems to be a little bit of risk taking as fears of bad news were not entirely confirmed," said David Powell, currency analyst at IDEAglobal in New York.
Dollar buyers were also cheered by Morgan Stanley's announcement of a $5 billion investment from China, which drew attention away from writedowns that caused the bank to post a net loss of $3.59 billion in the fourth quarter.
The trading ranks are likely to think out further as the week goes on, but those who remain at their desks will get weekly jobless claims and the Philadelphia Fed's manufacturing index to scour for clues about U.S. economic health.
Richmond Fed President Jeffrey Lacker said on Wednesday U.S. growth would remain weak for several more months while inflation remains a concern. For more, see [ID:nN19616024].
The weak business confidence reading in Germany came at a time when inflationary pressures were rising in the euro zone, suggesting that the European Central Bank may have a tough time raising rates any time soon, analyst said.
Such a situation could help the dollar regain further lost ground against the euro, with analysts less optimistic that the Fed would aggressively cut interest rates next year after inflation data last week pointed to lurking price pressures.
"The Ifo survey ... highlights the difficult situation that the ECB is going to face in the medium term: a slowing euro zone economy and rising price pressures," said Omer Esiner, forex analyst at Ruesch International in Washington.
But Schlossberg said the ECB is "far more concerned about price pressure than a slowdown," and the ECB's "uber-hawkish" stance on inflation means investors "still favor the euro."
The Bank of Canada and Bank of England, by contrast, have cut rates this year and could cut again in early 2008. (Additional reporting by Lucia Mutikani; Editing by James Dalgleish)