Euro firms as dollar rally fades

LONDON - The euro moved off last week's 1-1/2 month lows against the dollar on Monday, as a dollar rally on stronger than expected U.S. data gave way to consolidation and volumes thinned by a U.S. public holiday.

The yen weakened against the euro and held near a 13-month low against the dollar despite growing expectations the Bank of Japan will lift interest rates this week. A quarter point move would take rates to 0.5 percent, still leaving the yen under pressure as a low-yielding currency.

Strong data releases on the U.S. economy, including jobs and retail sales numbers, have dampened expectations of a near-term interest rate cut from the Federal Reserve.

In contrast, European Central Bank President Jean-Claude Trichet signaled last Thursday that the ECB would wait till March before raising rates from the current 3.5 percent, disappointing those who had banked on a February move but still sounding a robust note on the health of the euro area economy.

"After such dramatic moves in the last week and the week before, the market is just consolidating. It will probably track sideways until the U.S. producer price index data on Wednesday and consumer prices on Thursday which could give a bit more dollar direction," Westpac currency strategist Geoff Kendrick said.

By 1526 GMT, the euro was up 0.1 percent on the day at $1.2936 , rebounding from a 1-1/2-month low of $1.2864 hit on Friday. The single European currency has lost around 2 percent against the greenback so far this year.

Sterling extended gains started after the Bank of England surprised markets with a rate rise last week, hitting a 2-1/2 year high versus the euro and an eight-year peak against the yen . It was up 0.3 percent at $1.9640 , its strongest in more than a week.

The dollar stood at 120.46 yen , off Friday's 13-month peak of 120.74 yen. The euro rose to 155.87 yen , up a third of a percent on the day.

BOJ AWAITED

Investors believe the BOJ is likely to raise overnight rates to 0.5 percent, which would be the highest since 1995, despite warnings from some officials that the central bank should wait to support recovery from deflation.

"We expect the Bank of Japan to raise rates this week despite broad opposition by government officials, because failure to do so will trigger renewed downward pressure on the Japanese currency and provoke a new wave of yen carry trades," Ashraf Laidi, chief FX analyst at CMC Markets in New York said in a note to clients.

"Last week's rate hike from the Bank of England, expectations of further tightening from the European Central Bank ... are all conspiring to produce further yen selling against high yielding currencies," he added.

Japan's vice finance minister Hideto Fujii said on Monday he hoped the BOJ would support steady economic growth through its monetary policy.

A Reuters survey on Monday showed most market players expect the BOJ -- which raised interest rates for the first time in six years last July -- to raise them again at its two-day policy meeting which will end on Thursday.

But even a BOJ rate rise would not erode the huge yield advantage of other major currencies, with both U.S. and British short-term rates at 5.25 percent and Japan's central bank seen moving slowly on any further policy tightening.

Japanese data on Monday showed core machinery orders rose by a better-than-expected 3.8 percent on the month in November, reinforcing market expectations for a BOJ rate rise.

Japanese newspapers reported at the weekend the BOJ was likely to lift rates this week, viewing the economy as strong enough to withstand a rate rise and believing consumer spending will stay on a rising trend.