FOREX-Improved US outlook sparks dollar rally

* Dollar at 3-1/2-month high; euro, sterling fall

* Second Greece downgrade stokes worry about euro zone

* More upbeat Fed economic view helps dollar

* Some say too early to call end of dollar downtrend (Updates prices, adds detail on euro daily move, Bernanke nomination, comment)

By Steven C. Johnson

NEW YORK, Dec 17 (Reuters) - The dollar soared on Thursday, hitting a 3-1/2-month high against the euro, a day after the Federal Reserve highlighted improvement in the U.S. economy and stood by plans to shutter most emergency lending by February.

The euro, which tumbled to near $1.43 for the first time since September, also struggled after Standard & Poor's became the second rating agency to downgrade Greece in just over a week, stoking fears about the public finances of the euro zone member.

Data showing U.S. jobless claims unexpectedly rose last week tempered dollar gains, but a regional U.S. factory index improved, leaving the greenback near a two-month high against sterling and up more than 1 percent on the Australian dollar. For more, see [ID:nN17380585]

"The U.S. economy is picking up, and the Fed acknowledged this by saying it will stop most of its quantitative easing by Feb. 1, while the Greece issue might create a bad cloud over the euro zone economy," said Hidetoshi Yanagihara, senior currency trader at Mizuho Corporate Bank in New York.

The euro fell more than two U.S. cents to $1.4305 , according to Reuters data, its lowest level since Sept. 7. It was down 1.6 percent on the day and on track for its biggest daily decline since early July. It also fell 1 percent to 129.21 yen .

Light trading volume ahead of the holidays may have contributed to the scope of the dollar's gains, traders said, as did investors squaring up their portfolios before year end.

The dollar rose 0.6 percent to 90.29 yen , its third straight day of gains against the Japanese currency. Yanagihara said a recent push higher in U.S. bond yields reflected U.S. economic improvement while Japan faces deflation risks.

"We've hit some stops and liquidity is a bit thin, so the move's a bit exaggerated, but there's no question, the U.S. is likely to come out of its tailspin faster than Western Europe and Japan," said Mark Frey, director of FX trading at Custom House in Victoria, British Columbia, a global payments dealer.

But Alan Ruskin, chief international strategist at RBS Securities, said the dollar could retreat again in coming weeks if the euro fails to move below its 200-day moving average of $1.4175. "Only a concerted break of this level would lead to reevaluation of the dollar's longer-term trend," he said.

Traders said a Senate panel's approval of the nomination of Fed Chairman Ben Bernanke for a second term had little impact.

GREECE WEIGHS, AUSSIE RETREATS

The Fed gave no indication in Wednesday's statement that it was set to raise interest rates from near zero, stressing that they would stay low for an extended period. But it highlighted improvements in the economy, which markets have seen reflected in a slower pace of job losses and improved retail sales data.

Greek assets, meanwhile, took a lashing after Standard & Poor's cut Greece's rating by one notch to BBB-plus from A-minus late in European hours on Wednesday. [ID:nLDE5BG1RK]

Sterling hit a two-month low beneath $1.61 and was last down 1.2 percent at $1.6132 . The dollar also hit a 3-1/2-month peak against a basket of currencies <.DXY>.

The Australian dollar, which has ridden three central bank interest rate hikes to multi-month highs of late, hit a 10-week low at $0.8848 and was last off 1.7 percent.

For most of 2009, the dollar has struggled on the view that the Fed would keep interest rates low longer than other central banks and that the U.S. economy would lag the global recovery.

(Additional reporting by Gertrude Chavez-Dreyfuss in New York and Jessica Mortimer in London, Editing by Chizu Nomiyama and Andrew Hay )