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Dollar Slips on Profit Taking; Weaker Yen Expected

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The dollar fell from 2 1/2-year peaks against the yen on Monday in subdued trading as investors locked in profits after the greenback's recent rally, although its uptrend is likely to hold given expectations of further monetary easing in Japan.

The euro slid from an 11-month high against the dollar set on Friday, with traders reporting option barriers starting from $1.3480.

But analysts said the common currency looked poised for further gains, which could lift it toward the psychologically important $1.35 level.

Selling the yen has been a one-way trade since mid-November as investors believed Japan's new Prime Minister Shinzo Abe will push the Bank of Japan into more forceful monetary easing to beat deflation.

(Read more: Japan Leader Urges Swift Action From Central Bank)

Increasing rhetoric from Japanese authorities that they are open to the dollar rising to the 100 yen level has helped weaken the currency further, raising eyebrows abroad and sparking talk that Japan is triggering a currency war.

"It's not a question of direction in dollar/yen, which is higher. It's a question of the pace of the dollar/yen's climb," said Michael Woolfolk, senior currency strategist at BNY Mellon in New York.

Woolfolk expects the dollar to maintain its gains above the 90 yen level in the short term, climb to 94 by mid-year and 98 by the end of the year. "100 (in dollar/yen) is a foregone conclusion, but it will be a story for 2014," he said. The dollar fell 0.1 percent to 90.78 yen.

It had earlier risen as high as 91.25 yen on Reuters data, hitting a 2 1/2-year high for the third consecutive session. The dollar had briefly recovered against the yen after data showed U.S. durable goods orders rose more than expected in December. But the momentum faded after the release of disappointing U.S. pending home sales data.

The euro fell 0.2 percent to 122.10 yen, after climbing to a 21-month high of 122.89 yen on Reuters data.

Against the dollar, the euro was little changed at $1.3451, slipping from an 11-month high of $1.3479 set on Friday. Traders cited option expiries at $1.3400, which could act as support in the near term.

"After such a strong move up (in euro/dollar) it is normal for markets, at least in the short run, to not see much additional buying and see some profit-taking," said Ulrich Leuchtmann, head of FX research at Commerzbank.

(Read More: ECB's Draghi: Darkest Clouds Over Euro Zone Have Passed)

Analysts said the outlook for the euro zone improved and the common currency looked poised for further gains, which could lift it toward the psychologically important $1.35 level, the highest since December 2011. Ahead of the $1.35 level, major resistance for the euro/dollar includes its 2012 high of $1.3486 and the 50 percent retracement from the high in May 2011 to the low in July 2012 at $1.3492, traders said.

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"If we can break through $1.35, it takes us into a new trading range," Woolfolk said. "Our view is that during the first half of the year, the dollar will remain under pressure. We don't expect the Federal Reserve to change its dovish tone or its predisposition to continue expanding monetary stimulus." The Fed meets on Tuesday and Wednesday.

The first estimate of fourth-quarter U.S. economic growth and January payrolls readings are also due this week. Data showing an improving economic outlook for Germany and a greater-than-expected amount of loan repayment by European banks boosted optimism the euro zone crisis has turned the corner.

The European Central Bank is the first major central bank to start winding back some of its unconventional monetary policy measures. By contrast, the U.S. Federal Reserve and Bank of Japan have open-ended pledges to buy bonds to stimulate growth. More stimulus usually hurts a currency as it increases its supply.

Data on Friday showed speculators had increased their net long euro positions, while bets for further weakness in the dollar hits its highest since early October.

In the options market, traders reported demand for euro calls, which are bets on more gains. The one-month risk reversals traded at 0.1 vols in favor of euro calls, having flipped from puts toward the end of last week.

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