Dollar sinks on China diversification, stocks dip

LONDON, Nov 10 (Reuters) The dollar sank to a two-month low on Friday after further comments from China's central bank governor Zhou Xiaochuan on the bank's plans to diversify its $1 trillion in currency reserves, while European and Asia shares fell amid soft economic data.

Already under pressure after a weak reading of U.S. consumer sentiment, the dollar extended Thursday's losses after Zhou said China had a clear plan to diversify its FX reserves.

Zhou, speaking at a meeting of central bankers in Frankfurt, said diversification would include different currencies and investment instruments. Although Zhou said there was no change to China's long-standing diversification policy, many traders took his comments to mean China might buy fewer dollars as the country's massive current account surpluses swells its coffers.

''Undoubtedly, the dollar has weakened on the comments. But on the basis of the comments in and of themselves, I wouldn't expect the dollar to continue weakening,'' said Todd Elmer, currency strategist at Citigroup.

''I'd expect the trend of reserve diversification to be unfavourable for the dollar over time, but we have to be cautious.

I'm not sure this rhetoric means you should chase the dollar weakness, but I wouldn't expect significant dollar rebound in the near term,'' Elmer said, citing interest rate differentials in the coming weeks that are unlikely to be dollar-positive.

The dollar hit its lowest level in more than two months against a basket of major currencies and touched a 2-1/2 month low against the euro at $1.29 per euro.

The dollar and other currencies also came under pressure against the yen overnight after Bank of Japan Governor Toshihiko Fukui said he was concerned about a sharp unwinding of carry trades in which investors borrow the low-yielding Japanese currency and buy higher yielding currencies.

The dollar was buying 117.35 yen.

SHARES DIP The FTSEurofirst 300 was down 0.1 percent at 1,465.3 points, off Thursday's 5-1/2 year high as weakness in pharmaceutical stocks in particular weighed.

Concerns that drug companies may eventually face price controls from the U.S. government have arisen since Democrats won both the House of Representatives and the Senate in U.S. mid-term elections.

''The view is that for the next little while, that will be a headwind to drug companies in the U.S. It's a sentiment thing,'' said Stephen Dowds, head of international equities at Northern Trust.

AstraZeneca was down 2.2 percent and rival GlaxoSmithKline fell 1.7 percent.

However, equity markets overall looked attractive, with solid growth and reasonable company earnings, Dowds said.

''Corporate balance sheets are very strong, people are looking for growth and there's a lot of cash sitting on the sidelines in either private equity hands or even in quoted companies' balance sheets.'' Data showing the French economy unexpectedly stagnated in the third quarter did equities few favours, while weaker-than-expected machinery orders in Japan helped push the Nikkei to a one-month closing low of 16,112.4 points.

EURO ZONE BONDS FIRM The prospect of China diversifying further out of dollar denominated assets proved a boost for European government bonds on hopes they might attract more Chinese buying, but analysts noted it was a gradual process.

''It's been an issue for months. We are certainly seeing some diversification into euro zone bonds, but I don't think it's on as big a scale as many people think,'' said ING's Padhraic Garvey.

The December Bund future rallied to test key resistance at 118.00, up 18 ticks, while the 10-year note was yielding 3.718 percent.

Gold edged up as the dollar weakened and as investors speculated China would diversify into bullion or other commodities.

Zhou said diversification included currencies and investment instruments including emerging markets but asked if this included gold, he said: ''That's a separate thing.'' Spot gold was trading around $634 an ounce, having touched a two-month peak around $636.50.

Oil prices retreated, giving up most of Thursday's gains as traders booked profits. The International Energy Agency (IEA) noted that inventories in OECD nations had risen at a rate of 1.15 million barrels per day during the third-quarter, the highest third-quarter build in 15 years, but also predicted a jump in demand during the current quarter.

U.S. light crude was down 72 cents at $60.44 a barrel.

REUTERS SBA PM1749