SHANGHAI, Aug 19 (Reuters) - China's yuan touched a three-month low against the dollar on Friday, breaching a key threshold, after the central bank set a much weakened midpoint guidance, with traders expecting further downside due to an economic slowdown.

Prior to market opening, the People's Bank of China (PBOC) set the midpoint rate at 6.8065 per dollar, 263 pips or 0.39% softer than the previous fix of 6.7802, the weakest since Sept. 30, 2020.

That dragged the spot market past the psychologically important 6.8 per dollar level. The onshore yuan opened at 6.8050 per dollar and fell to a low of 6.8150, the softest level since May 13.

It traded at 6.8086 as of 0208 GMT, 216 pips weaker than the previous late session close.

Its offshore counterpart followed suit to touch a three-month low of 6.8288, before last fetching 6.8208.

Currency traders and analysts said a firmer dollar and weaker domestic economic fundamentals both contributed to the yuan's declines.

"We reiterate the USD/CNY 7.0 forecast for Q1 2023 with the expectation that the PBOC will not cap further upside in USD/CNY when the broad U.S. dollar uptrend resumes in coming weeks," analysts at RBC said in a note.

The PBOC is set to take more easing steps, pressured by a shaky economy that is undercutting jobs, but policy insiders and analysts say it faces limited room to manoeuvre due to worries over rising inflation and capital flight.

A recent slew of data showed the economy unexpectedly slowed in July, and recent power shortage and hot weather across the country are also adding to the strains on growth.

Moreover, a slowdown in the global economy and persistent supply-chain snags have narrowed the policy options for China.

The dollar surged to a one-month high earlier in the day as Federal Reserve officials spoke of the need for further rate hikes, and investors reevaluated minutes from the U.S. central bank's July meeting as being more hawkish than originally thought.

(Reporting by Winni Zhou and Brenda Goh Editing by Shri Navaratnam)