* Euro hits 2-1/2 year peak against dollar
* ECB disappoints bears, euro seen rising to $1.40
* Dollar/yen slips from 5-week high
* Expectations for U.S. jobs lowered by soft ADP, ISM reports
By Anirban Nag
LONDON, March 7 (Reuters) - The euro raced to a 2-1/2 year high against the dollar on Friday as short term money market rates rose on signs that the European Central Bank's balance sheet was contracting at a time when other major central banks were still expanding theirs.
More gains are likely if a key U.S. jobs report reflects the soft patch being felt by the world's largest economy.
The dollar slipped from a five-week high against the yen with its near-term fortunes hinging on the non-farm payrolls report, due at 1330 GMT. The data is likely to show job growth picked up enough in February to encourage the Federal Reserve to continue scaling back stimulus.
A Reuters poll of economists found employers were expected to have added 149,000 workers to their payrolls last month. But analysts said investors may be bracing for a weaker reading following the soft ADP private sector jobs report and ISM services sector survey released earlier this week.
The euro hit a 2-1/2 year high of $1.3915 in European trade, its highest since October 2011. The euro has made broad based gains after the ECB on Thursday decided to stand pat on policy and held off from fresh monetary stimulus.
"The ECB was quite disappointing to a lot of euro bears," said Yujiro Gato, currency strategist at Nomura, London. "We do not rule out a move towards $1.40 by the euro in the coming weeks given the ECB is unlikely to ease policy anytime soon."
The euro's gains accelerated on Friday after data from the ECB showed banks were set to repay a big chunk of its emergency 3-year loans next week. That repayment to the ECB shrinks its balance sheet size at a time when both the Federal Reserve and the Bank of Japan are expanding theirs by buying bonds.
The repayment of loans leads to a drop in excess liquidity, a factor which saw money market rates rise and boost the euro's allure.
Overall, investors are turning increasingly bullish about the euro after President Mario Draghi told a news conference that economic conditions in the region did not require a shift in monetary policy.
He also clarified that the euro's rise has only reduced inflation by 0.4 percentage points, comments which analysts said will likely to see more upside for the currency.
DOLLAR INDEX AT 4-MONTH LOW
The euro's surge saw the dollar index, which measures its value against a basket of major currencies, fall to a four-month low of 79.433.
Traders said they were geared up for a soft number due to weather disruptions and any number below 100,000 fresh jobs being created, could see the dollar drop against the yen.
"There's a very wide range on this one now. I think the market has already priced in a lower number," said Jeffrey Halley, FX trader for Saxo Capital Markets in Singapore, referring to the U.S. non-farm payrolls data.
"I think it would have to come in well under 100,000 for it to have any significant downside effect on dollar/yen," he added.
The dollar eased 0.2 percent to 102.95 yen. Earlier, the dollar touched a high of 103.17 yen, matching a five-week high that had been set on Thursday.
Manuel Oliveri, an FX strategist at Credit Agricole in London said they were expecting a soft U.S. jobs number but most of the market are of the view that this was because of the bad weather and A loss of momentum in the economy was temporary.
"As a result, dollar/yen is unlikely to drop much," he added.
- USA News