FOREX-Euro holds line on dollar, drops against sterling

Reuters

(Updates with early New York trade, changes dateline, previous LONDON)

* Euro steady after big falls in last two sessions

* Sterling gains on euro, hits 16-month peak

* Ukraine referendum condemned in Europe, markets unmoved

* ECB's Nowotny says rate cut not enough to combat low inflation

By Daniel Bases

NEW YORK, May 12 (Reuters) - The euro held modest gains against the dollar and yen on Monday, unperturbed by the weekend referendum in Ukraine in which pro-Russian rebels declared victory in a self-rule vote, further escalating tensions.

Against sterling however, the euro fell to a 16-month low on growing bets the European Central Bank will ease monetary policy just as the Bank of England prepares to raise interest rates.

"We think that near-term data is likely going to allow market participants to continue to romance the possibility that the Bank of England becomes the first of the G4 central banks to embark on policy tightening," said Brian Daingerfield, currency strategist at the Royal Bank of Scotland in Stamford, Connecticut.

"Certainly the stronger data is likely to lead the market to see the BOE's dovish message as perhaps a bit less credible," said Daingerfield.

Dealers said the market had calmed after a turbulent reaction to ECB President Mario Draghi's statement last week that the bank was "comfortable" with easing monetary policy in June.

Analysts pointed to appearances by some of Draghi's colleagues - most notably Bundesbank chief Jens Weidmann - as possible sources of more clarity on whether the bank is really ready to act.

The euro's gains were trimmed after Austrian central bank chief Ewald Nowotny told reporters it would take more than a cut in interest rates to combat low inflation in the euro zone.

Expectations for a BOE rate increase helped push the yield premium offered by two-year British gilts over euro zone bonds to its biggest since 20008. A BOE quarterly inflation report on Wednesday could include changes to the central bank's interest rate outlook, given Britain's stronger-than-expected economic recovery.

The euro fell as low as 81.43 pence, its weakest against sterling since January 2013. Sterling rose 0.12 percent to $1.6870.

However, the euro traded up 0.06 percent against the greenback at $1.3765, having tumbled last week from a 2-1/2 year high of $1.3995.

Markets showed little reaction to the Eastern Ukraine voting, which overwhelmingly supported self-rule.

The European Union declared the referendum illegal and increased pressure on Russia on Monday by taking a first step toward extending sanctions to companies, as well as people, linked to Moscow's annexation of Crimea.

"The story has been going on for a while and unless there is a significant escalation, at least in G10 markets, they have learned how to live with it," said Vassili Serebriakov, currency strategist at BNP Paribas in New York.

"There were some concerns about the referendum obviously, but it looks like risk is holding up fairly well," he said.

The euro edged up 0.24 percent to 140.51 yen, up from a two-month trough of 139.84 yen hit Friday. The dollar rose 0.25 percent to 102.10 yen.

(Reporting by Daniel Bases; Additional reporting by Patrick Graham and Anirban Nag in London, Ian Chua in Sydney and Masayuki Kitano in Singapore; Editing by Toby Chopra and Dan Grebler)

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