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By Simon Falush
LONDON, Dec 21 (Reuters) - The dollar fell half a cent versus the euro on Friday as investors took profits on the U.S. currency's rally to two-month highs and thin end-of-year trading conditions exacerbated market volatility.
Worries about the health of the U.S. financial sector were reignited by a Wall Street Journal report that U.S. investment bank Merrill Lynch & Co Inc (MER.N: Quote, Profile, Research) may get a capital infusion of up to $5 billion from Singapore state investor Temasek Holdings [ID:nN20230794].
Credit crunch concerns were also prompted by news that MBIA Inc, the world's largest bond issuer, said it has exposure to $30.6 billion in complex mortgage securities that it insures, more than its entire net worth [ID:nN20582225].
"Investors are worrying whether bond insurers are set to get a big wave of writedowns and that weighed briefly on the dollar," said Chris Turner, head of FX strategy at ING.
U.S. data also took a slight turn for the worse on Thursday, with the Philadelphia Fed's survey showing that factory activity in the U.S. mid-Atlantic region plunged to its weakest in over four years -- potentially giving another excuse to lock in profits on the dollar's gains from earlier in the week.
The dollar index .DXY was down 0.2 percent at 77.630, retreating from a two-month high of 77.854 hit on Thursday.
The euro <EUR=> rose a third of a percent to $1.4367 <EUR=>, pulling away from a two-month low of $1.4308 touched on Thursday.
The Merrill fund infusion report refocused the market's attention on worries about U.S. financial institutions' losses from the credit market crisis and was negative for the dollar, traders said.
But some said the market reaction may not be necessarily one-way because fund injections to investment banks can be seen as relief rather than a cause of worries, because they offset losses that had been incurred.
HIGH YIELDERS RALLY
The New Zealand dollar rallied 0.9 percent against the dollar to $0.7656 <NZD=>, helped by a slightly stronger than expected growth figure for the third quarter.
This, together with a strong performance on equity markets, helped prop up fellow high-yielder the Australian dollar <AUD=>.
The low-yielding yen -- often used as a source of cheap funding for carry trade bets in currencies like the Aussie and kiwi -- stayed on the back foot.
The dollar was up 0.2 percent at 113.31 yen <JPY=>, while the euro was up half a percent at 162.76 yen <EURJPY=>.
Sterling hit a 4-1/2 year low versus the euro, and came within 10 ticks of all-time troughs <EURGBP=> on expectations that UK interest rates may be cut as soon as next month.
A strong reading for British retail sales data briefly boosted sterling but the weakest consumer confidence reading in 12 years highlighted the negative outlook for the UK economy.
In the United States, November personal consumption expenditure figures -- the Federal Reserve's preferred inflation measure -- are released at 1330 GMT.
"The core PCE index is the principal release on the U.S. calendar this afternoon as markets debate the inflation environment and the ramifications of rising price pressures for Fed policy in 2008," Lloyds TSB Corporates & Markets said in a research note.
"A month-on-month increase in excess of 0.2 percent would probably see the market reinstate long dollar positions."
Markets are currently pricing in a nearly 90 percent chance of a Fed cut to 4 percent in January, and a total of 100 basis points worth of monetary easing between now and next September. (Additional reporting by Toni Vorobyova; Editing by Ron Askew)