* Dollar index trades above last week's 3-year low
* Treasuries auction seen as test of investor appetite
* Short-covering seen supporting dollar
* Graphic: World FX rates in 2018 http://tmsnrt.rs/2egbfVh
LONDON, Feb 20 (Reuters) - The dollar continued its rebound from three-year lows on Tuesday, on the view that the currency was due a modest correction after a sharp decline in recent weeks, and as traders eyed a large U.S. debt auction.
The U.S. Treasury is preparing to sell more than a quarter of a trillion dollars' worth of new debt this week, which analysts said would be a key gauge of international investors' appetite for U.S. assets, after a broad sell-off on worries over the United States' ballooning fiscal deficit.
The dollar climbed broadly ahead of the first tranche of the auction later in the day, when $179 billion in Treasury bills and two-year notes will be auctioned.
"This offers an important test of the weak dollar narrative: if we see weak auctions, particularly for the 2-, 5- and 7-year paper, it would confirm that the market is concerned about the U.S. fiscal outlook this year," wrote Saxo Bank's head of currency strategy, John Hardy, in a note to clients.
"Successful auctions this week... (would) provide a challenge to the weak dollar consensus."
The greenback has decoupled from U.S. Treasury yields since the start of the year, skidding to its lowest levels since late 2014 against a basket of major currencies despite 10-year Treasuries approaching 3 percent for the first time in four years.
That correlation breakdown has puzzled many investors. Economists have explained it by saying that the rise in yields has not so much been driven by expectations for higher interest rates and stronger growth, as by worries about rising inflation that have caused a selloff in both the dollar and Treasuries.
But on Tuesday, the dollar rose 0.6 percent against its index to 89.632, as 10-year U.S yields climbed back up to 2.92 percent.
"I think we're seeing some people who were short for the past month just taking some profit - I don't think there's any reassessment in the dollar," said ING's head of currency strategy, Chris Turner.
Any positive impetus from rising U.S. interest rates has been offset by a barrage of bearish factors in recent months, including worries over the deficit, concerns that the government it pursuing a weak dollar strategy, and other central banks moving towards policy tightening.
Against the yen, the dollar climbed half a percent to 107.16 yen, having bounced back from a 15-month low of 105.545 set on Friday.
The euro eased half a percent to $1.2342, backing down from Friday's three-year high of $1.2556. (Reporting by Jemima Kelly; Additional reporting by Hideyuki Sano in Tokyo; Editing by Raissa Kasolowsky and Peter Graff)