* Earthquake rattles markets

* Aussie down in sympathy but outperforms kiwi

By Ian Chua

SYDNEY/WELLINGTON, Feb 22 (Reuters) - The New Zealand dollar fell more than one full U.S. cent on Tuesday after a strong earthquake hit the country's second biggest city Christchurch, prompting markets to price in a small chance of an interest rate cut.

The strong quake killed and trapped people beneath rubble and was the second to hit the city in five months.

New Zealand government bond yields dropped across the curve with the 2-year yield hitting seven-month lows at 3.78 percent, while the one-year swap rate slid to 3.17 percent, lows not seen since September 2009.

"With the NZ economy still in a fragile state, such a shock can only dent confidence further," said Khoon Goh, head of market economics and strategy at ANZ.

Westpac Bank analysts said there was a chance the central bank would cut rates to boost confidence. Markets are now pricing in a 20 percent chance of a 25 basis point cut and have slashed their rate hike expectations for the next 12 months by about half to just 28 basis points.

The kiwi dollar slid to an eight-week low of $0.7493, having earlier traded as high as $0.7640. It was last down 1.9 percent at $0.7494.

Traders said the decline was so severe because the market had initially supported the kiwi on expectations that dairy processor Fonterra Co-operative Group Ltd, the country's largest company, would raise its forecast payout to farmers on the back of strong global prices.

While that eventuated, traders said the quake caught markets offguard, forcing many players to hastily unwind long positions.

The kiwi also fell more than 1 percent against the yen to 62.46 , while the euro rose more than 1 percent to NZ$1.8013 .

The market is also worried the earthquake could add stress to the government's already strained finances, giving credit-ratings agencies the excuse to downgrade New Zealand's ratings.

S&P and Fitch have negative outlooks on New Zealand's sovereign ratings, but a S&P spokesman said it was still too early to assess the economic impact of the quake, while Fitch said the tremor would not, of itself, trigger a downgrade.

AUSSIE WILTS

In sympathy with the kiwi, the Aussie fell against the greenback, but strongly outperformed its New Zealand peer, rising to a near two-month high of NZ$1.3368, from as low as NZ$1.3163 .

The move also coincided with a blowout in the 1-year AU/NZ swap spread to 265 basis points -- the widest since late December -- as the decline in the New Zealand swap rate outpaced its Aussie counterpart, making the Aussie more attractive relative to the kiwi.

Versus the greenback, the Aussie was down about 0.7 percent on the day at $1.0022 .

Australian government bond futures rose, with the three-year contract climbing 0.05 points to 94.830 and the 10-year contract up 0.025 points to 94.380.