By Jessica Mortimer
LONDON (Reuters) - The euro hit its highest in four years against the yen and a near one-month peak versus the dollar on Wednesday after Germany's two major parties reached a deal on forming a grand coalition.
German Chancellor Angela Merkel's conservatives clinched a deal with the Social Democrats in the early hours, triggering a relief rally for the euro. A new government should be formed before year-end.
The euro was also supported by a survey showing German consumer sentiment at a six-year high. This followed unexpectedly robust Ifo business sentiment figures issued last week.
"The coalition agreement in Germany suggests an expansionary budget, which should be positive for the euro," said Hans Redeker, head of global foreign exchange strategy at Morgan Stanley.
However, he said levels above $1.36 provided opportunities to sell the euro, which has gained more than 2 percent since the European Central Bank cut interest rates earlier this month.
The euro was up 0.3 percent at $1.3597, having earlier touched $1.3613, its strongest since October 31.
It hit 138.54 yen, leaving it the potential to target the 2009 peak of 139.26 yen. It last traded at 138.37 yen, up m0.7 percent on the day.
"The grand coalition in Germany removes a big political uncertainty and will support the euro in the short term," said Arne Lohmann Rasmussen, head of currency research at Danske Bank in Copenhagen.
He and other analysts expected euro gains against the dollar would be limited due to the prospect of further monetary easing from the ECB and of the U.S. Federal Reserve scaling back stimulus next year. Rasmussen recommended selling the euro if it strengthened to $1.37/$1.38.
Traders also warned low volumes before Thursday's U.S. Thanksgiving holiday may exaggerate currency movements.
Concerns remained about a weak euro zone economy and deflationary pressures that may prompt further action from the ECB. However, euro zone inflation data on Friday is expected to show a small acceleration, an outcome that could help the euro.
The dollar was up 0.5 percent against the yen at 101.82 yen, with the low-yielding Japanese currency pressured by higher equities. This took it close to Monday's six-month high of 101.915 yen.
However, the dollar dipped against a basket of currencies (.DXY).
Investors were also watching developments in the East China Sea, after two U.S. B-52 bombers on a training mission flew over disputed islands without informing Beijing. Some analysts said any escalation in tensions may lift the safe-haven yen, which has weakened in recent weeks.
Sterling hit an 11-month high of $1.6328 after third-quarter UK gross domestic product data suggested the country's recovery was broadening.