FOREX-Dollar pauses after strong gains, euro's gains capped

Reuters

* Dollar index hovers near two-month peak

* Solid U.S. jobs data keeps alive December tapering viewfor now

* Diverging Fed/ECB policy path expected to mute euro

NEW YORK, Nov 11 (Reuters) - The dollar rally paused onMonday after two days of strong gains, with a further rise seendepending on whether U.S. bond yields keep rising amidintesifying debate on when the Federal Reserve will scale backstimulus.

The euro has struggled as the Fed and the European CentralBank's diverging monetary policy paths prompt investors to sellthe currency at higher levels.

But a U.S. government holiday kept many investors on thesidelines on Monday and with volumes low the euro managed somerecovery though analysts cautioned against reading too much intoMonday's trading.

"It's a very quiet day with more of a relief bounce" in theeuro, said David Song, Currency Analyst at DailyFX in New York."I think the euro could be in line for another move lower fromhere."

The euro climbed to $1.3406 on lower-than-usualvolumes but gains were capped as investors began tosell it at around $1.3400. The euro hit a two-month low of$1.3295 last Thursday after the ECB surprised the market bycutting its main interest rate to a record low 0.25 percent.

"The dollar has come off slightly, but the defining factor isthe rise in the U.S. yields," said Jeremy Stretch, head ofcurrency strategy at CIBC World Markets in London. "The dollarwill be supported and for the euro any bounce towards $1.34 willbe sold into."

The dollar index fell 0.2 percent to 81.148, havingset a two-month high of 81.482 on Friday after a report showedU.S. employers added 204,000 new jobs last month, much more thanthe 125,000 new jobs expected.

The strong data was even more surprising as it came in amonth when a budget standoff in Washington forced a 16-daygovernment shutdown, suggesting the U.S. economic recovery wason a firmer footing than previously thought.

As a result U.S. yields rose, with the gap between two-yearU.S. Treasuries and their German counterparts at its widest since mid-July. U.S. bond markets wereshut on Monday, and with yields rising quickly in the past week,some expected Treasuries to consolidate.

The 10-year U.S. yield was also near a two-monthhigh as some investors brought forward to December theirexpectations of when the Fed will start to withdraw stimulus.That underpinned the dollar as rising yields make a currencymore attractive to hold. After the government shutdown, most hadpushed back Fed "tapering" expectations to March 2014.

SELL THE EURO

Speculators have cut long euro positions and this trendcould gather pace with the euro zone facing a prolonged periodof falling inflation. That could see the ECB deploying moreaggressive monetary easing instruments.

"We think investors are caught long near $1.3450, witheuro/dollar primed for a move toward $1.32, a level euro zoneand U.S. two-year yield differentials would point toward," saidChris Turner, chief currency strategist at ING in London

Although the ECB's rate-setting committee was split aboutThursday's decision to cut rates, Executive Board member BenoitCoeure said on Saturday that the bank could trim interest ratesfurther and provide more liquidity.

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