The dollar climbed on Friday as the market bought the currency ahead of the weekend based on expectations for higher US interest rates after an investment bank raised their target for the benchmark federal funds rate.
The dollar had gained ground for most of the week as a parade of Federal Reserve speakers pointed to inflationary pressures in the US economy and vowed that the Fed would keep them at bay.
The comments reinforced expectations that the Fed would continue to raise rates, preserving or increasing the dollar's yield advantage over other currencies.
"I remain a steadfast dollar bull in the short term based on Fed policy and the widening of US interest rate spreads" over those in some other major economies, said David Mozina, head of foreign exchange strategy with Lehman Brothers in New York.
On Friday, Lehman raised its forecast for the US rate hike cycle to peak with the federal funds rate at 4.75 percent in March 2006, up from a previous 4.5 percent forecast.
"The combination of still-strong growth and rising inflation has prompted a string of hawkish Fed speakers all arguing strenuously for the need to keep inflation contained," Lehman economists wrote in a research note.
"The dollar wants to finish the week on strong footing," said Lara Rhame, vice president and foreign exchange strategist, Credit Suisse in New York. "I really think it is more position squaring" ahead of the weekend than fundamental news, Rhame added.
In late afternoon trading in New York, the euro was trading down 0.5 percent at $1.1950 after hitting a peak of $1.2077 earlier in the session.
The euro had slid to a three-month low of $1.1876 on Wednesday.
Against the Japanese yen, the dollar was up 0.5 percent at 115.86 yen and close to two-year peaks near 116 yen hit earlier in the week.
For the week, the dollar gained 1.6 percent against the yen while the euro declined 1.1 percent against the dollar.
But dealers and analysts cited mixed views on how much more of a lift the dollar can get from the yield play.
"It's done," said Ron Simpson, managing director and global currency analyst at Action Economics in Dobbs Ferry, New York.
"The recent run of dollar gains based on inflation and interest rate hike expectations is over and done with and now we are going to consolidate into next week and beyond," he said, adding "this dollar rally is becoming very fatigued."
The Fed has raised its benchmark interest rate 11 times since June 2004, taking it to 3.75 percent, and many economists expect it to raise rates twice more this year to 4.25 percent and quite possibly more next year.
Dealers said the euro's losses were blunted by comments from European Central Bank chief economist Otmar Issing said central banks have to be "extremely vigilant" against inflation, sparking speculation the ECB may raise rates sooner than later.
But later in the day, ECB President Jean-Claude Trichet said that inflation risks had risen in the euro zone and strong vigilance was needed, but current interest rates were still appropriate.
The euro zone interest rate futures market now sees a nearly 40 percent chance of the ECB raising rates by a quarter percentage point in December. The ECB has kept rates steady at 2.0 percent for over two years now.
Richard Franulovich, senior currency strategist at Westpac Banking Corp in New York, said rising speculation the ECB would raise rates in coming months was changing the relative picture for yield differentials.
"For well over a year, the single most dominant trend has been the Fed story, but now we have the added complication that the ECB could be hiking next year, there are dimming prospects for a BoE (Bank of England) ease and the Bank of Japan is getting away from zero interest rates," said Franulovich.
"That does muddy the picture, but I still think the Fed will be doing more work in raising rates and I would be more comfortable buying dollars at the low end of the range than selling them at the top," he said.
Sterling fell 0.3 percent against the dollar to $1.7679 while the greenback gained 0.4 percent against the Swiss franc to 1.2921 francs.
The Canadian dollar eased against the US currency after a mixed Canadian retail sales report for August. Overall sales fell 0.3 percent from the prior month, but sales were up 0.2 percent excluding autos.
The US dollar was up 0.8 percent at C$1.1874.
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