The dollar hit a two-month low against the euro and a basket of major currencies on Thursday after soft inflation and manufacturing data sparked concern about the strength of the U.S. economy.

Data showing a third straight monthly decline in producer prices came a day after Federal Reserve meeting minutes showed policymakers think they may need to do more to boost the economy if a sputtering recovery slows any further.

That helped drive the euro above $1.28 for the first time since early May. Worries about sovereign debt in the 16-country euro zone had pushed it below $1.19 in June.

A gauge of factory activity in New York state also fell sharply, while first-time applications for U.S. jobless benefits fell slightly.

The data is going to give traders further reason to dump the dollar as the risk shifts from Europe to the United States, said Kathy Lien, director of FX research at GFT Forex in New York. Overall, U.S. fundamentals are making the U.S. less attractive to investors.

The euro rose 1 percent on the day to $1.2877 EUR=, its highest level since early May, while the dollar fell 0.8 percent to 87.71 yen JPY=. The dollar also hit a three-month low at 1.0452 Swiss francs CHF= while sterling rose to a 2-1/2-month peak of $1.5371 GBP=D4.

Traders said strong demand for overnight euro/dollar call options with strikes at $1.2825, $1.2835 and $1.2855 had facilitated a rally in the euro.

Citing the weaker U.S. growth outlook, Goldman Sachs now forecasts the euro to trade at $1.22 in three months' time rather than $1.15, as it predicted in June. It's six- and 12-month forecasts are $1.35 and $1.38, respectively, compared to $1.15 and $1.25 a month ago.

TECHNICALS SUGGEST DOLLAR TROUBLE

Better-than-expected quarterly profits from JPMorgan Chase & Co (JPM.N) also boosted risk appetite and higher-yielding currencies such as the Australian dollar.

That contrasted with soft economic data, which hurts the dollar because investors fear it hints the economy may take a turn for the worse in the second half of 2010.

Over the near term, the dollar is likely to continue to struggle if data continues to come out towards the weaker end of expectations. That would tend to add to the dollar's heavier tone, said Joe Manimbo, analyst at Travelex Global Business Payments in Washington.

Strategists said technical indicators were flashing a breakdown of the dollar's recent trend higher. The dollar index .DXY, which measures the greenback against six major currencies, hit a two-month low and passed the 38.2 percent retracement of an trend up that began in November and peaked in early June.

Technical analysts also highlighted the euro's break above the $1.2785 mark for the first time since December 2009. They said a close above that level was key to further gains.

A move towards $1.30 is realistic for the euro, but we don't see it lasting. If U.S. data continues to deteriorate, it won't be long before that's being replicated elsewhere, said Derek Halpenny, European head of currency research at BTM/UFJ.

(Additional reporting by in Nick Olivari and Wanfeng Zhou in New York and Jessica Mortimer in London; Editing by Padraic Cassidy)

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