* Dollar falls from 3-1/2 month highs vs euro, basket
* U.S. new home sales hit seven-month low in November
* U.S. consumer sentiment rises but misses estimates
* Canadian dollar hits more than 2-week high vs greenback (Updates prices, adds comment, details)
By Wanfeng Zhou
NEW YORK, Dec 23 (Reuters) - The dollar declined for the first time in five sessions against the euro on Wednesday after U.S. new home sales unexpectedly fell to a seven-month low last month, denting optimism about the economy.
The government's housing report also included a downward revision to the previous month's figure, just one day after an industry report showing a 7.4 percent increase in November existing home sales had increased hopes the hard-hit housing market was stabilizing.
Trading was extremely thin, which may have exaggerated currency moves; Tokyo markets were closed for a national holiday and many market players elsewhere have already wound down for the Christmas holidays and year-end.
"It's clearly a disappointing number," said Nick Bennenbroek, head of currency strategy at Wells Fargo in New York. "You're going to get bumps along the road every so often as far as recovery is concerned. It might change sentiment regarding interest rates and the dollar a little bit."
Optimism about the U.S. economy had stoked expectations the Federal Reserve may raise its borrowing costs sooner rather than later, pushing the dollar to a 3-1/2-month high versus the euro and a basket of six major currencies the previous day.
Analysts said the dollar also dropped as investors sought to lock in gains on the greenback's recent rise.
"You've seen a big move in euro/dollar already. Folks are taking some profits on their long dollar positions ahead of the holiday," said Samarjit Shankar, managing director of global FX strategy at BNY Mellon in Boston.
In midday trading, the euro was up 0.8 percent at $1.4357, rebounding from a 3-1/2-month low of $1.4216 on Tuesday after a third rating agency downgraded Greece's credit rating.
Adding to pressure on the dollar was a survey showing that although U.S. consumer sentiment rose in December, it fell short of analyst expectations and trailed the preliminary December figure.
Against the yen, the dollar last dropped 0.5 percent to 91.41 yen, after earlier climbing to 91.87 yen, its highest level since late October, according to Reuters data.
CANADIAN DOLLAR RALLIES
The ICE Futures dollar index, which values the greenback against a basket of six currencies, fell 0.6 percent to 77.775, down from a 3-1/2-month peak of 78.449 hit on Tuesday.
Sterling fell after minutes from the Bank of England's December policy meeting showed that officials felt little had changed since November, which was seen as leaving the door open to a further expansion of the central bank's asset buying program.
"The minutes confirm that the committee is in wait-and-see mode until February, but don't close the door entirely on further policy action of some sort," said Jonathan Loynes, economist at Capital Economics.
The pound fell as low as $1.5924, one tick from Tuesday's trough, which was the weakest level since mid-October. It was last little changed at $1.5966.
The Swiss franc rose against the euro to 1.4878. Traders remained wary of possible action by the Swiss National Bank to curb the franc's strength. The dollar fell 1.2 percent to 1.0361 francs.
The Canadian dollar hit a more than two-week high against the U.S. currency after Canadian Finance Minister Jim Flaherty said in an interview with Bloomberg that China and Russia may diversify their currency reserves into Canadian dollars. The greenback last dropped 1 percent to C$1.0471. (Additional reporting by Steven C. Johnson; Editing by Leslie Adler)