* Euro hits three-week high, but gives up gains
* Investors see rise in U.S. yields as overdone
* FOMC expected to stick with QE mantra
* Australian dollar breaks parity with greenback
(Updates prices, adds US data, comment, changes byline)
By Steven C. Johnson
NEW YORK, Dec 14 (Reuters) - The euro hit a three-week high against the dollar on Tuesday but gave up gains as U.S. bond yields edged higher and investors squared positions ahead of the last Federal Reserve meeting of the year.
After last week's deal to extend U.S. tax cuts for all earners and the subsequent rise in long-dated yields, traders said the market will watch closely for any sign that the Fed could speed up or alter a $600 billion bond-buying program designed to push long-term interest rates lower.
"The Fed could be interesting depending on how vocal they are in either committing to the full amount now that they've got additional fiscal stimulus or whether they feel they have to step on the gas to get rates back down," said Brian Dolan, chief strategist at Forex.com in Bedminster, New Jersey.
Dolan said the euro, which began the week at $1.32 and hit a three-week high near $1.35 overnight, could rally further if it closes above $1.3450, with a move to $1.37 possible.
But traders said that would likely require the Fed to sound an aggressive note on its easing program. Markets expect the central bank to reaffirm policy when it meets at 2:15 p.m. while acknowledging improved economic data. [ID:nFEDAHEAD]
The euro was last changing hands at $1.3383
The Australian dollar
Traders also said year-end positioning and low trading volume as exaggerating some price swings.
US YIELDS STILL IN FOCUS
Data Tuesday showed U.S. retail sales rose by more than expected in November, suggesting U.S. growth is gaining traction. [ID:nN13201818]
The tax cut deal, agreed to last week by President Barack Obama and congressional Republicans, has prompted economists to upgrade their U.S. growth forecasts, but it also pushed up bond yields for fear it will swell the U.S. deficit.
The dollar rose with yields last week but fell on Monday when Moody's warned the tax cuts could move it a step closer to cutting the U.S. triple-A credit rating. [ID:nN13105751]
Some strategists said fear of imminent U.S. inflation and higher long-term rates was premature.
"The recent rise in front-end U.S. yields looks overdone as core inflation isn't going to pick up quickly," said Gavin Friend, currency strategist at nabCapital.
"Also euro zone bond spreads seem to have stabilized on the back of the recent ECB buying which has helped the euro.
The European Central Bank stepped up its purchases of government bonds last week, although the amount bought was still well below levels reached last spring.
The euro also hit a three-week high against the yen
But it fell after the S&P rating agency said Belgium's sovereign debt could be downgraded within six months, reminding investors of contagion risks from the euro zone crisis. [ID:nWEA7396]
(Additional reporting by Neal Armstrong in London; editing by )