Euro gains as stronger stocks hurt dollar; yen hits five-month high

By Tommy Wilkes

LONDON (Reuters) - The euro gained on Tuesday as gains in global equity markets encouraged traders to sell the dollar and tiptoe back into riskier assets.

The dollar was down as much as half a percent against a basket of currencies, reversing some of its gains of last week, when it enjoyed its performance since 2016.

"It's an interesting combination of the return of risk appetite and U.S. bond yields also dragging the dollar," said Alvin Tan, London-based FX strategist at Societe Generale (PA:SOGN), adding there was little euro-specific news to push the single currency higher.

A sharp sell-off in stock markets last week drove traders to unwind one of the most popular bets of the year - buying the euro on expectations the European Central Bank will scale back its stimulus later this year amid a strong recovery in the bloc's economy.

Although many market players remain bullish on the euro, the currency lacks clear catalysts for further gains as a March election in Italy and a fragile coalition deal in Germany create an uncertain political backdrop.

Though risk appetite appears to be recovering, emerging market currencies that sold off last week failed to make much headway, with the Turkish lira , Mexican Peso and Russia's rouble (RUB=) all treading water.

The commodity-linked Australian and Canadian dollars were also trading flat.

"Market sentiment is still fragile," Tan said.

YEN HITS FIVE-MONTH HIGH

The dip back into riskier assets initially helped to lift the dollar against the yen but the upbeat mood quickly disappeared when traders saw Japanese shares failing to maintain hefty gains.

The yen, which enjoyed a bounce against the dollar last week thanks to its reputation as a relative safe haven, hit a five-month high.

The greenback fell 0.9 percent to 107.655 yen as the Nikkei (N225) erased a 1.4 percent intraday gain to end down 0.7 percent at a four-month closing low.

Prospects of higher inflation globally have rattled investors this month and have helped drive equity market falls.

Higher inflation could prompt the U.S. Federal Reserve to tighten policy faster than expected. Alternatively, if the Fed fails to act fast enough and falls behind the curve on policy, it could end up pushing up long-term bond yields. In either scenario, traders worry that U.S. economic growth could be hampered.

There were some indications such fears are beginning to subside, with the MSCI's all-country world index (MIWD00000PUS) rising 1.2 percent.

"I think markets will remain shaky until (Federal Reserve Chairman Jerome) Powell's congressional testimony on Feb. 28. Markets will try to test him until they hear his thinking," said a trader at a U.S. bank.

The South African rand gained 0.1 percent to trade at 11.91 rand to the dollar after reports the ruling African National Congress party executive committee had decided to remove President Jacob Zuma as head of state.