* Dollar gains, Aussie tumbles as China raises rates
* U.S. Treasury's Geithner comments support dollar
* China move sparks risk aversion; dollar still vulnerable (Updates prices; adds comment, details)
By Wanfeng Zhou
NEW YORK, Oct 19 (Reuters) - The safe-haven dollar headed for its best day in two months on Tuesday, while the euro and commodity-sensitive Australian dollar tumbled after a surprise interest rate increase from China prompted investors to cut risk exposure.
Investors feared a quarter-percentage point rise in China's one-year lending rate could dampen Chinese and global growth and slow the country's voracious demand for commodities, many of which come from Australia. For details, see [ID:nBJI002412]
The dollar climbed to a two-week high versus the euro, pushing the single currency near $1.37. Still, some analysts said the market's reaction was overblown and with the Federal Reserve set to ease monetary policy further as early as next month, any dollar rebound will be short-lived.
"China's rate increase instantaneously pushed people to take risk off the table," said Boris Schlossberg, director of research at GFT Forex. "(China) is trying to clamp down on growth and that's going to reflect badly on Australia, on Germany, on much of the world economy as it readjusts to the idea that Chinese growth may not be as torrid as expected."
The Australian dollar, which last week rose above parity with its U.S. counterpart for the first time since 1983, was hit hardest, slipping 2.2 percent to $0.9681 AUD=D4. At current prices, it marks the biggest daily percentage decline since late June.
The euro was down 1.6 percent at $1.3726 EUR=, its biggest daily drop since August and off a $1.4005 session peak, according to trading platform EBS.
It tumbled as low as $1.3713, the weakest in two weeks, after U.S. stock selling accelerated on fears Bank of America (BAC.N: Quote, Profile, Research, Stock Buzz) may be forced to buy back mortgages. [ID:nN19153662]
Traders said the break of $1.3770 opens the door for a test of $1.37, followed by $1.3637, its Oct. 5 low and around $1.3580, the 38.2 percent retracement of its rise from Sept. 10 to Oct. 15.
The U.S. dollar index, which tracks the greenback versus a basket of six currencies .DXY posted its biggest daily gain since August, last trading at 78.223, up 1.7 percent.
DOLLAR STILL VULNERABLE
Hobbled by zero interest rates and expectations of more Federal Reserve easing to come, the dollar has been under pressure since September. Analysts, however, say the expectations of Federal Reserve easing have been priced in, providing an opportunity for investors to take profits.
The dollar's rebound began after the euro rose above $1.41 last week, an 8-1/2-month high. It continued on Monday after Treasury Secretary Timothy Geithner said Washington would not devalue the dollar for export advantage. [ID:nLDE69I00W]
Analysts cautioned, however, that any sustained dollar seemed unlikely given expectations that U.S. interest rates will remain low relative to most other major economies.
"The fundamentals are still pretty well lined up against the dollar and I expect it to come under renewed pressure in the near term," said Daniel Katzive, currency strategist at Credit Suisse in New York.
New York Fed President William Dudley said Tuesday that employment and inflation are likely several years away from being within the Fed's comfort zone. [ID:nNLLJLE6KI]
Societe General strategist Kit Juckes said the China news was "not a game changer" and that high-yielding currencies such as the Australian dollar and Brazilian real are likely to attract buyers following their recent retreat.
The dollar rose 0.4 percent to 81.56 yen JPY=, its best daily gain since Japan intervened to weaken the yen on Sept. 15. It hit a 15-year low beneath 81 yen last week. The Australian dollar/yen exchange rate, an important barometer of risk sentiment, fell 1.7 percent to 79.04 yen AUDJPY=R.
The U.S. currency also rose 1.4 percent to 1.0311 Canadian dollars CAD= after the Bank of Canada left interest rates at 1 percent and cut is growth forecast. [ID:nN19118876] (Additional reporting by Steven C. Johnson; Editing by Diane Craft)