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FOREX-Dollar drops in thin trade; U.S. growth prospects cap losses

* Major currencies in holding pattern

* Christmas holiday keeps markets subdued

* U.S. consumer spending posts largest increase in five months

* International Monetary Fund will raise U.S. growth forecast

By Julie Haviv

NEW YORK, Dec 23 (Reuters) - The dollar fell against the euro on Monday in illiquid trade, but optimism about the U.S. economy despite the Federal Reserve starting to withdraw some of its stimulus capped the currency's losses.

Major currencies were in a holding pattern due to a holiday in Japan, while for most of Europe it was the last full trading session before a Christmas break. That left many investors and speculators to square positions and trim long dollar positions before year-end.

U.S. consumer spending posted its largest increase in five months in November, the latest reading of sustained strength in the economy as the year winds down.

The report fit the Fed's upbeat view on the economy, which prompted the U.S. central bank to announce last week that it would start reducing its monthly bond purchases from January.

"The risk this week has more to do with flows and potential positioning into year-end," said Camilla Sutton, chief currency strategist at Scotia Bank in Toronto.

"As we move into a holiday-laden week, liquidity is likely to be lighter than usual. Accordingly, any large flows leading into year-end could make for awkward movements," she said.

In early afternoon trade, the dollar was flat at 104.08 yen , not far from a five-year peak of 104.63 yen touched on Friday.

Sentiment globally was underpinned by Friday's upbeat U.S. GDP data and the Federal Reserve's decision last week to start scaling back its bond-buying stimulus.

International Monetary Fund Managing Director Christine Lagarde said on Sunday the international lender would raise its U.S. growth forecast for the world's largest economy next year.

"While the potential for speculative dollar/yen profit taking remains substantial given yet another new high, the underlying trend of yen weakness should persist into the new year," said Adam Myers, European head of FX strategy at Credit Agricole.

"Our expectations for dollar buying in early 2014, complementing yen selling pressure should resume and see dollar/yen move higher toward our 106 yen end-March forecast," he said.

The euro traded 0.2 percent higher at $1.3698, above a two-week trough of $1.3623 on Friday. Against the yen, the common currency was 0.2 percent higher at 142.58, not far from a five-year high of 142.89 reached last week.

Part of the reason why the dollar remains sought-after is that short-dated Treasury yields are still moving higher, driven by expectations the Federal Reserve will continue to trim its bond-buying program in coming months.

The 10-year Treasury yield rose and if forthcoming activity out of the United States continues to outperform.

Rate differentials will likely continue to favor the dollar.