* Dollar index touches near 2-week high
* Euro at 22-month low versus British pound
* Euro zone data lags, weighs on euro (Recasts after German data, adds quote)
By Anirban Nag
LONDON, July 7 (Reuters) - The euro fell on Monday, hitting a 22-month trough against the British pound, after weak German industrial data highlighted the divergent economic prospects between the euro zone and those of its biggest trading partners.
German industrial output fell 1.8 percent on the month in May, its biggest drop in more than two years, and surprised most who had forecast an unchanged reading. It kept alive expectations that the European Central Bank would have to loosen monetary policy further in coming months in the face of disinflationary pressures and subdued economic growth.
In contrast, the Bank of England is expected to tighten policy before the end of this year or early next year. Investors have also brought forward the timing of the first rate hike by the U.S. Federal Reserve to the middle of 2015 after a stellar jobs report last week.
That helped the dollar index trade near its highest in nearly two weeks, at 80.359. The euro was down 0.1 percent at $1.3576, its lowest since July 26, while it fell to a 22-month low against the pound of 79.14 pence after the German data.
"The German data was a bit weak and in line with recent euro zone data. This will add to selling pressure in the euro in the near term," said Yujiro Goto, currency analyst at Nomura.
He expected euro/dollar to drift lower, especially in light of last week's U.S. jobs data. The strong non-farm payrolls report prompted traders to slightly increase bets that the Fed will lift rates in June next year.
Most traders are cautious about adding to long dollar bets, aware that Fed policymakers will probably err on the side of caution or wait for wage inflation to pick up before hiking rates.
Fed minutes, due to be released later this week, should shed more light on how the debate within the rate-setting committee is shaping up, traders said.
The dollar's failure to make much headway has been the big disappointment on currency markets this year. Most traders say that unless two-year Treasury yields rise sharply, the dollar, which has a good correlation to U.S. yields, is unlikely to push much higher.
The dollar held steady versus the yen near 102.14 yen , after having risen 0.7 percent last week.
"It wouldn't be surprising to see a rise toward 102.50 yen," said Bart Wakabayashi, head of foreign exchange for State Street Global Markets in Tokyo, referring to the near-term outlook for the dollar against the yen.
"But if you ask whether we will see a new trend, that probably won't be the case," he added.
Sterling slipped slightly against the dollar to $1.7150, but stayed within easy reach of last week's six-year high of $1.7180 . The Canadian dollar, also in favour at the moment, stood at C$1.0655 per USD, just off a six-month high of C$1.0620 struck on Thursday.
The Australian dollar, in contrast, was still smarting from Reserve Bank of Australia Governor Glenn Stevens' remarks about it being overvalued. The Aussie, nursing a 0.7 percent loss last week, eased 0.1 percent to $0.9355.
(Additional reporting by Masayuki Kitano; Editing by Susan Fenton)
- Europe News