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FOREX -Dollar pauses after strong gains, euro's gains capped

* Dollar index hovers near two-month peak

* Solid U.S. jobs data keeps alive December tapering view

* Diverging Fed/ECB policy path expected to peg back euro

By Anirban Nag

LONDON, Nov 11 (Reuters) - The dollar paused on Monday after two days of hefty gains, with a further rise seen dependent on whether U.S. bond yields keep rising as debate intensifies on when the Federal Reserve will scale back stimulus.

The euro struggled to make headway as the Fed and the European Central Bank's diverging monetary policy paths prompted investors to sell the currency at higher levels.

The euro climbed to $1.3390 on lower-than-usual volumes but gains were capped as most investors were selling it at around $1.3400. The euro hit a two-month low of $1.3295 last Thursday after the ECB surprised the market by cutting its main interest rate to a record low 0.25 percent.

"The dollar has come off slightly, but the defining factor is the rise in the U.S. yields," said Jeremy Stretch, head of currency strategy at CIBC World Markets. "The dollar will be supported and for the euro any bounce towards $1.34 will be sold into."

The dollar index fell 0.2 percent to 81.139, having set a two-month high of 81.482 on Friday after a report showed U.S. employers added 204,000 new jobs last month. That handily beat forecasts for 125,000 jobs.

The strong data was even more surprising as it came in a month when a budget standoff in Washington forced a 16-day government shutdown, suggesting the U.S. economic recovery was on a firmer footing than previously thought.

As a result U.S. yields rose, with the gap between two-year U.S. Treasuries and their German counterparts at its highest since mid-July. U.S. bond markets were shut on Monday, and with yields rising quickly in the past week, some expected Treasuries to consolidate.

The 10-year U.S. yield was also near a two-month high as some investors brought forward expectations of when the Fed will start to withdraw stimulus to December. That underpinned the dollar as rising yields make a currency more attractive to hold. After the government shutdown, most had pushed back Fed "tapering" expectations to March 2014.


Speculators have cut long euro positions and this trend could gather pace with the euro zone facing a prolonged period of falling inflation. That could see the ECB deploying more aggressive monetary easing instruments.

"We think investors are caught long near $1.3450, with euro/dollar primed for a move toward $1.32, a level euro zone and U.S. two-year yield differentials would point toward," said Chris Turner, chief currency strategist at ING.

Although the ECB's rate-setting committee was split about Thursday's decision to cut rates, Executive Board member Benoit Coeure said on Saturday that the bank could trim interest rates further and provide more liquidity.