Fear that the U.S. recovery is faltering drove the dollar to a three-month low against a basket of currencies on Monday and the euro broke above $1.3125, a key technical level, to hit its highest since May.

Strong earnings from European banks, including HSBC, helped lift sterling to a six-month high against the greenback, while the Australian dollar hit a three-month peak after data showed Chinese manufacturing expanded for a 17th straight month.

Signs of weaker U.S. growth have hobbled the dollar in recent weeks. Data on Friday showed growth slowed to a 2.4 percent annual rate in the second quarter and Federal Reserve Chairman Ben Bernanke said on Monday the economy is still far from achieving full recovery.

But the Chinese data and recent solid reports from Europe have investors hopeful the world economy can grow even if the U.S. recovery sputters. That has boosted risk appetite and pushed currencies through important technical levels.

Analysts said the euro's rally appears to be gaining momentum after it tested $1.3125. That marked a three-month high and the 38.2 percent retracement of a decline that began in November and took the euro to $1.1876 in June, its lowest since 2006. It was last up 1 percent $1.3174, its highest level since May 4.

A close above $1.3125 would be a bullish sign, analysts said, with $1.3510, the 50 percent retracement of the November-to-June move, a potential target. But traders said barriers around $1.3150, $1.3200 and beyond could make it a slow and difficult climb.

An index of the dollar .DXY against six major currencies fell 0.7 percent and was nearing its 200-day moving average, another important technical level that, if breached, could suggest further losses ahead, analysts said.

It's a broad dollar-weakness story right now, said Sebastien Galy, senior strategist at BNP Paribas in New York. If we close above key technical levels on the euro, we may be in for a sharp acceleration.

Sterling rose 1.3 percent to a six-month high of $1.5896 and hit a four-week high against the euro. Robust results from HSBC (HSBA.L)(0005.HK) and BNP Paribas (BNPP.PA) helped risk sentiment on Monday, as European shares rose 2.5 percent .FTEU3.

The dollar was flat at 86.49 yen, off an eight-month low of 85.95 yen hit late last week. Japanese Finance Minister Yoshihiko Noda said on Monday excessive yen movements were undesirable because of the currency's impact on the economy and markets.

U.S. data released on Monday showed the manufacturing sector slowed a bit in July but by less than economists had expected. U.S. employment data for July will be released on Friday.

What's happening is the rest of the world doesn't look so bad and the U.S., while sluggish, doesn't look dire yet, said Joseph Trevisani, chief analyst at FX Solutions in Saddle River, New Jersey.

The U.S. economy's been on an even keel for six months, not really going up or down. So as long as China doesn't fall off a cliff, the easy currency play is to keep buying risk, particularly the Australian and Canadian dollars, he said.

The dollar also fell against the Australian and Canadian dollars, with the Aussie hitting a three-month peak at $0.9143. Strong Chinese data tends to help the Aussie dollar.

(Additional reporting by Nick Olivari in New York and Neal Armstrong in London; Editing by Dan Grebler)