By Gertrude Chavez-Dreyfuss
NEW YORK (Reuters) - The euro dropped to a three-week low against the dollar and fell sharply versus the yen on Thursday after data painted a bleak picture of the euro zone economy, raising expectations the European Central Bank will cut interest rates.
The yen, meanwhile, rallied from recent multi-year lows against the dollar as investors grew cautious a day ahead of a meeting of Group of 20 finance officials where exchange rates are expected to be an important topic. A particular focus would be on the yen's recent weakness.
It was the third straight day of gains for the yen, rising 1.5 percent. That was the best three-day advance for thre Japanese currency in three weeks.
After being overshadowed by the yen the last few sessions, the euro regained the market's attention after a report showed the euro zone economy shrank by 0.6 percent in the last three months of 2012, a steeper decline than the 0.4 percent drop forecast in a Reuters poll.
Germany and France, the two largest economies of the 17-nation euro zone, also shrank by more than expected in the final quarter, casting doubt on forecasts of a recovery in early 2013.
"With the growth outlook trimmed, the ECB must show a willingness to remain flexible with regard to monetary policy to avoid a deeply entrenched recession that could be devastating," said Sean Cotton, vice president and foreign exchange advisor at Bank of the West in San Ramon, California.
The euro last traded at $1.3356, down 0.7 percent, after hitting a three-week low of $1.3313. The euro had hit a one-week high of $1.3520 on Wednesday and a 15-month high of $1.3711 on February 1.
Against the yen, the euro was last at 124.01 yen, down 1.3 percent on the day.
Valentin Marinov, currency strategist at CitiFX in London said the euro's recent weakness was consistent with indications that the market got excessively long the currency across the board.
An "aggregate misevaluation" indicator developed by CitiFX showed that that euro has appreciated in excess of fundamentals, Marinov said, and the currency could drop further in the near term if investors continue to unwind longs.
Euro zone banks' next repayment of emergency loans to the ECB later this month could also weigh on the euro, analysts said. These banks are expected to repay a lower amount than they did last month and cause the ECB's balance sheet shrink at a slower pace.
The euro is up around 1.0 percent against the dollar and about 8.4 percent against the yen this year, largely a result of an improved appetite for risk and differing global central bank policies.
G20 IN FOCUS
The Group of Seven nations said this week fiscal and monetary policies must be directed at domestic economies and not at targeting exchange rates. But confusion reigned after a G7 official said the statement was aimed at Tokyo, a comment that prompted the yen to surge on a volatile foreign exchange market.
Other G7 countries later said it should be taken at face value.
Host Russia said the G20 meeting in Moscow would back the thrust of a Group of Seven statement on currencies, but indicated there was still haggling over the final wording.
Frances Hudson, global thematic strategist at Standard Life Investments in Edinburgh, Scotland said she doesn't expect Japan to be singled out for its currency policy at the G20 meeting. But if the G20 does call out Japan, some of the countries within the group would be on weaker ground, she added.
"There are countries within the G-20 that actually set exchange rate targets. And that isn't what Japan is doing," Hudson said.
"Japan is doing what seems to be actions for economic reasons, such as tackling deflation. Japan didn't come out and say our objective is a weaker yen. Its objective is to achieve inflation."
Standard Life manages assets of about $263.9 billion.
Against the yen, the dollar was down 0.6 percent at 92.87 yen, well below a 33-month high of 94.42 hit on Monday. It hit a low of 92.65 yen in late trade.
Earlier, the Bank of Japan kept policy steady as expected and revised up its assessment of the Japanese economy. Some believe the bank may hold off on expanding stimulus next month and wait until its first rate review under a new governor, scheduled for April 3-4.
(Additional reporting by Julie Haviv; Editing by Diane Craft)