By Veronica Brown LONDON (Reuters) - The dollar staged a broad rally on Tuesday to hit a 1-1/2-year high against a basket of currencies, fueled by demand from banks for funding needs while investors unloaded highly-leveraged positions. The U.S. currency also found favor after Federal Reserve Chairman Ben Bernanke endorsed on Monday more government spending to stimulate the flagging U.S. economy. By contrast, the euro lost ground because of market expectations that there was scope for the European Central Bank to cut interest rates aggressively. Yen strength reflected underlying nerves on the global economic outlook. While interbank lending has started to revive from a state of near-paralysis, the dollar and yen benefited as investors continued to liquidate highly-leveraged positions. "The deleveraging story will continue and remain in place for quite some time," said Audrey Childe-Freeman, senior FX strategist at Brown Brothers Harriman in London. "The other interesting thing coming through is the policy responses to the crisis. I think the U.S. remains ahead on that front." The dollar index, which measures the U.S. currency's value against a basket of six currencies, rose to 83.646 .DXY, its highest since March 2007. The euro hit its lowest since March 2007 at $1.3197, down around 1 percent on the day. Traders cited overnight speculation that banks needed more dollars to settle credit derivatives tied to the bankruptcy of Lehman Brothers. The dollar fell 1 percent against the yen to 100.95 yen,, while the euro dropped 1.9 percent to 133.34 yen. FUNDAMENTALS TO REIGN AGAIN? As financial markets regain some poise, analysts said the market's focus was switching to economic fundamentals and monetary policy. Fed chief Bernanke said on Monday the economy was expected to be weak for several quarters and there was some risk of a protracted slowdown. Fed policymakers meet next week, and economists and investors expect rates to be cut again from their current 1.5 percent. The Fed and other major central banks eased monetary policy in coordination earlier this month. "Central banks will at least take heart from the ongoing drop in Libor spreads over their policy rates that monetary policy may once again be able to influence the real economy," Calyon strategists said in a note to clients. The high-yielding Australian dollar fell 2.6 percent against the U.S. dollar on expectations the Reserve Bank of Australia would also ease monetary policy again. RBA minutes from its meeting earlier this month indicated there was more room for rate cuts, though these were unlikely to be as aggressive as this month's full one percentage point cut. (Reporting by Veronica Brown; Editing by David Stamp)

Source