* Dollar hits lowest this year versus major currencies
* Euro breaks above $1.39, highest since early January
* Risk appetite, worries about U.S. debt weigh on dollar
* S&P cuts UK outlook to negative from stable
* Pound recovers from early sharp slide (Adds comment, detail)
By Steven C. Johnson
NEW YORK, May 21 (Reuters) - The dollar on Thursday plunged to its lowest level this year against major currencies, and the euro approached a five-month high above $1.39 as worries about swelling U.S. deficits soured investors on U.S. assets.
Standard & Poor's announcement that it could downgrade Britain's triple-A credit rating initially weighed on sterling. But Pacific Investment Management Co's Bill Gross said fear the United States may face the same predicament slammed the dollar and drove the 10-year Treasury yield near a two-week high.
"No one wants to admit it but there might be investors nervous enough with the extreme levels of indebtedness of the U.S. government so that just the thought of a downgrade would provide an excuse to sell dollars," said Matt Esteve, a trader at Tempus Consulting in Washington. "If such a thing happened, the impact would be huge."
The U.S. Treasury on Thursday said it would sell another $101 billion in notes next week. [ID:nN21559422]
The euro was up 1 percent at $1.3899 <EUR=>. Earlier, it hit $1.3923, its highest level since early January. The dollar was down 0.6 percent at 94.25 yen, near a two-month low beneath 94 yen <JPY=>. An index gauging the dollar's strength against a basket of six major currencies hit its lowest level this year. .DXY
S&P's warning on the UK initially lifted the dollar by some 3 cents against sterling, but the pound recovered and hit a 6-1/2-month high near $1.59 before easing back to $1.5861 <GBP=>, up 0.8 percent from late Wednesday.
Alan Ruskin, chief international strategist at RBS Greenwich Capital, said S&P's announcement on the UK might be seen as an early warning for other heavily indebted countries, chiefly the United States.
Asked Thursday about U.S. sovereign rating concerns, S&P cited its January affirmation of U.S. triple-A status, saying it considers fiscal deterioration temporary. [ID:nN21288440]
U.S. Treasury Secretary Timothy Geithner said Thursday he considers maintaining a strong dollar and confidence in the economy his "basic obligation." [ID:nN21456605]
The dollar has fallen every day this week against the euro and sterling, and it marked its third straight decline against the yen on Thursday.
Earlier this week, analysts attributed the fall in the dollar, which has been treated as a lower risk, safe-haven investment, to growing optimism that the worst of the financial crisis has passed, causing investors to unwind positions in favor of the U.S. currency built up when fear was widespread, credit was frozen and stock markets were in free fall.
"You're seeing a cyclical unwinding of the safe-haven trade," said Sebastien Galy, senior currency strategist at BNP Paribas in New York.
But with less need to buy dollars as a safe haven, analysts said investors were finding it harder to ignore the effect of the Federal Reserve's zero interest rate policy and its efforts to keep long-term rates low through direct purchases of U.S. government debt.
Barclays Capital strategist Steven Englander said that's particularly so when central banks in the euro zone, Canada and Australia have stuck with policies less likely to increase deficits or inflation, lending support to their currencies.
"If growth is highly dependent on extremely low interest rates and an unprecedented set of monetary and fiscal policies that require issuing of a lot of Treasuries for a long time," that will not bode well for the dollar in the long run, Englander said. (Additional reporting by Wanfeng Zhou and Vivianne Rodrigues; Editing by Leslie Adler)