* Dollar index hovers near 10-month peak after July rally
* Volatility ticks up from rock bottom, but jury still out
* Nonfarm payrolls data next major focus (Updates after European PMI data, sterling move)
By Patrick Graham
LONDON, Aug 1 (Reuters) - The dollar climbed towards multi-month highs against several major currencies on Friday and headed for a third week of gains, signalling that a year of low volatility and poor trading returns may be ending.
Sterling, one of the main victims of a 2 percent global surge for the dollar in July, sank to its weakest since early June after a poorer-than-expected survey on UK manufacturing. The euro proved more resilient in the face of similar disappointing surveys of German and euro zone purchasing managers, trading just 0.05 percent lower on the day.
Trade was likely to be dominated by U.S. nonfarm payrolls, due at 1230 GMT. Dealers said a strong gain could make or break a rally that has seen the dollar post its best monthly performance in more than a year.
"Its all or nothing today, I'd say," said one London-based trader. "There is the feeling that the euro has been forming a base over the last day or so, but either way payrolls should decide."
Against a trade-weighted basket of currencies, the dollar index was 0.1 percent higher at 81.51. It came close to a 10 1/2-month peak of 81.573 in morning trade.
The euro traded at $1.3389. The yen fell just over 0.1 percent to 102.94 yen, below a four-month high of 103.15 yen reached on Wednesday. Sterling lost around another half cent to as low as $1.6829.
The central question for currency markets this year has been when the dollar will climb out of the range where it has been stuck since before the 2008 financial crisis. Such a move is widely expected to bring with it a return of the sharper market moves traders rely on to make money.
There have been tentative signs of a return of such price action. Volatility as measured by 3-month options contracts has risen steadily from record lows over the past month but remains around 5.4. Currency platform and trading chiefs say they need vols of at least 7-8 to generate healthy returns.
"It does feel like we've broken through the trendline support that has held for most of the past year," said Paul Robson, a currency strategist with RBS in London.
"The market are a little bit long dollars, and if we do get an upside surprise on payrolls it may need to be a good bit higher than consensus. But on balance we like staying long dollars, with the yen maybe the cleanest trade on payrolls."
A Reuters survey of economists forecast that payrolls, due at 1230 GMT, increased by 233,000 in July.
While that would be less than June's 288,000 jobs, it would still represent a sixth straight month that employment has grown by more than 200,000, a stretch not seen since 1997.
"If it comes in above 250,000, I think that's the threshold for a positive surprise," said Callum Henderson, global head of FX research for Standard Chartered Bank in Singapore.
Such an outcome could lift the dollar to levels around 103.50 to 104.00 yen, he said. Standard Chartered, however, is expecting nonfarm payrolls to increase by a below-consensus 200,000, and for the dollar to pull back to levels around 102.50 yen, Henderson added.
(Additional reporting by Masayuki Kitano in Singapore; Editing by Larry King)