FOREX-Dollar rally stalled by yen as market takes breather

By Veronica Brown

LONDON, Feb 7 (Reuters) - The dollar dropped sharply after nearing a seven-week high against the yen on Tuesday, with the Japanese currency gaining on position adjustment, but fresh gains were seen for the greenback on a positive U.S. interest rate outlook.

Analysts said that the dollar's interest rate-powered strength had given way temporarily to a buyback in the yen, but recent strong U.S. data and upbeat Federal Reserve comments would allow the U.S. currency to resume its rise.

"What we're seeing right now is the market take a bit of a breather. One thing we've seen in the past two days is yen weakness against the crosses and that probably has to do with the fact that the yen sell-off in the past week or so has been the sharper move," Barclays Capital currency strategist Adarsh Sinha said.

"Now we're seeing a pullback in yen weakness. But our view is that you will see further yen weakness ahead," he added.

By 0903 GMT, the dollar was at 118.13 yen , down 0.78 percent on the day -- having hit a seven-week high of 119.39 on Friday.

The euro was down half a percent at a one-week low of 141.72 yen , with traders citing sell-stops as the market approached 142.00. The euro gained slightly against the dollar to $1.1981 having earlier moved closer to Monday's one-month low of $1.1943.

German industrial production data is due at 1100 GMT in an otherwise thin European calendar.

Production is expected to have risen by 0.7 percent in December, after falling 0.3 percent in November.


FED'S FISHER REASSURES

Dollar bulls had taken heart from Dallas Fed President Richard Fisher, who said on Monday he fully expects the Fed to keep control of inflation, encouraging market views that there is more monetary tightening to come.

His comments follow data last week showing upward revisions to job growth and a fall in the unemployment rate to a 4-1/2-year low, reinforcing the outlook for the Fed to keep lifting overnight rates after 14 straight rises to 4.5 percent.

"The market is starting to talk about 4.75 percent and the risk of the Fed perhaps moving to five and even beyond," Barclays' Sinha said.

But some analysts said further gains for the dollar may be limited in the near term, with no major U.S. economic data until later in the week.

European Central Bank President Jean-Claude Trichet said on Monday the bank was ready to raise interest rates again at any time to keep inflationary pressure in check, backing market expectations for a March rate hike to 2.5 percent.

Foreign buying of U.S. Treasuries at this week's auctions totalling $48 billion should help the dollar, traders said. The first auction of three-year notes will be held later on Tuesday.

Some said Japanese institutional investors may buy some of the revived 30-year bonds, helping the dollar climb further against the yen. Japan's Ministry of Finance sells only a limited amount of such longer-dated bonds.


RATES TO DOMINATE

Traders and analysts said the market would next shift its attention to December data on U.S. trade, due on Friday.

Some market players said the focus was unlikely to shift to the growing U.S. twin trade and budget deficits, as rising U.S. interest rates have helped the United States attract more than enough foreign capital to finance these shortfalls.

"Sentiment for the dollar is so strong at the moment that I don't think the market will start worrying about the deficits," said a trader at a Japanese bank.

Median estimates by analysts point to a widening of the U.S. trade gap to $65 billion in December from November's $64.2 billion. Citibank expects the deficit to blow out to a record $68.5 billion due to a surge in imports.

The United States' reliance on foreign capital has been exacerbated by the steady rise in the U.S. budget deficit, which the government projects will rise to $423 billion in fiscal 2006, up more than $100 billion from the previous year.

Treasury Secretary John Snow will testify before Congress on the budget at 1500 GMT.