* Futures markets lift probability of U.S. rate increases
* Long euro positions wilt as dollar bounces
* Graphic: World FX rates in 2017 http://tmsnrt.rs/2egbfVh
LONDON, Sept 27 (Reuters) - The dollar climbed half a percent on Wednesday against a broad basket of currencies as optimism about U.S. fiscal reforms and hawkish talk from the central bank pushed bond yields higher.
Extreme short bets against the greenback has been one of the most crowded trades in the currency markets this year as investors have been disappointed by the progress on fiscal reforms and the slow pace of increase in U.S. interest rates.
But futures markets have rapidly increased the likelihood of a U.S. rate rise by December in recent days to as much as 70 percent, compared to less than 20 percent from only a month ago thanks to recent hawkish comments by Fed Chair Janet Yellen.
"Yellens comments have been broadly positive for the dollar, firming up probabilities for a December hike but we have quarter end coming up and there are the Chinese holidays next week so would be careful to read much into these moves shorter-term," said Josh Byrne, an FX strategist at Citibank in London.
The Trump administration and Republicans in Congress are due to announce a tax plan later on Wednesday. If passed, it would be the first significant legislative victory for U.S. President Donald Trump since he took office in January.
Rabobank strategists say that if the tax reforms raises the chances of the U.S. sustaining a 3 percent growth rate, then it will be a significant boost for the dollar which has suffered this year and is poised for its biggest annual drop since 2004.
Investors have also scrambled to cover their short dollar bets fuelled by a rise in U.S. yields.
Bearish positions against the dollar against a broad basket of currencies are at their biggest since January 2013 and one trader at an Asian bank reported some short covering in positions.
Two-year U.S. Treasury yields climbed to their highest level since October 2008 while the yield curve flattened to its tightest levels since the third quarter of 2016.
The dollar's gains has compounded woes for the euro this week which has already been suffering from the unexpected results of the German elections this week which potentially marks the end of a period of political stability in Europe, according to analysts.
"The divergence between U.S. and euro zone data surprises is closing rapidly and while the once popular dollar parity forecasts still look ridiculous, the euro looks past its peak," said Sean Maher, an independent macro-strategist based in London.
Having gained more than 14 percent this year, the single currency has given back nearly 3 percent since hitting a January 2015 peak of $1.2092 earlier this month as investors rapidly repriced expectations of a U.S. rate increase in the coming days.
The euro slipped 0.5 percent to $1.1740 in early trades, its lowest level since Aug. 23. It has fallen nearly 2 percent this week against a resurgent greenback.
The euro weakened against other currencies as well, hitting a 10-week low against the British pound and a two-week low of 1.14075 Swiss franc.
For Reuters Live Markets blog on European and UK stock markets see reuters://realtime/verb=Open/url=http://emea1.apps.cp.extranet.thomsonreuters.bi z / c m s / ? p a g e I d = l i v e m a r k e t s (Reporting by Saikat Chatterjee)