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FOREX -Tighter money market conditions and ECB stance buoy euro

Anirban Nag
Tuesday, 10 Dec 2013 | 4:01 AM ET

* Euro extends recent gains on dollar and yen

* Dollar index drops for second straight day

* Fed's Bullard talks about possibility of small taper in Dec

LONDON, Dec 10 (Reuters) - The euro hit a fresh five-year high on the yen and a six-week peak against the dollar on Tuesday as expectations for further near-term stimulus from the European Central Bank faded.

Tighter money market conditions in the euro zone, as reflected in the rise of two-year swap rates partly due to year-end factors and the ECB's policy outlook, are seeing rate differentials more in favour of euro.

Against the dollar, the euro was at $1.3755, up 0.1 percent and getting closer to a two-year high of $1.3833 set in late October. The euro was steady at 141.90 yen having hit 142.19, a high not seen since October 2008.

The euro has gained over 1.5 percent against the dollar since the ECB last week refrained from following up November's surprise rate cut and said it has yet to come up with a detailed plan of which policy tools to use and when.

"It is a combination of lack of urgency on the part of the ECB and the tighter liquidity conditions that are driving the euro higher," said Alvin Tan, currency strategist at Societe Generale. "The year's high of $1.3833 is definitely in play and we could expect it to go even higher."

Liquidity conditions in the euro zone money market usually tighten into year end as banks refrain from lending to each other, but this year another factor that is driving euro's strength is European banks repatriating funds to shore up their capital base ahead of the ECB's asset quality review.

The review will be based on banks' balance sheets at the end of 2013.

"Unless the ECB identifies a way and announces a method to counter these tight liquidity conditions, euro/dollar could be dragged as high as $1.39 by year-end," said Chris Turner, head of currency strategy at ING.

DOLLAR DIPS

The euro's rise saw the dollar index extend losses into a second straight day. It hovered near six-week lows, dragged down by lower U.S. Treasury yields.

Traders said investors seemed to have pretty much priced in the risk of the Federal Reserve scaling back monetary policy soon, which might help explain why the dollar has not risen broadly in the past few sessions.

Economists polled by Reuters on Monday expect the Fed will begin reducing its massive bond-buying programme in March, but some are warming up to the idea of a December or January taper.

James Bullard, the St. Louis Fed president, said the Fed could slightly reduce its monthly bond purchases this month in reaction to signs of an improved labour market. The Fed holds its policy meeting next week.

Against the yen, though, the greenback held at 103.22 yen and was close to a five-year peak of 103.74 set in May.

One possible concern for yen bears is that support for Japanese Prime Minister Shinzo Abe dropped after he steamrolled through parliament a tough secrecy act that critics fear could muzzle media and allow officials to hide misdeeds.