* Big short yen bets could unwind if BOJ signals policy shift
* Graphic: World FX rates in 2018 http://tmsnrt.rs/2egbfVh
LONDON, March 2 (Reuters) - The Japanese yen surged to a 16-month high against the dollar as investors sold the greenback as prospects of a trade war gripped currency markets after U.S. President Donald Trump announced hefty new tariffs on steel and aluminum imports.
Bank of Japan governor Haruhiko Kuroda also surprised currency markets by saying the central bank would consider an exit from its ultra-easy monetary policy if it met its inflation target in the year ending in March 2020, helping the yen higher against the euro and sterling.
The dollar was on the back foot even before Kuroda spoke, having pulled sharply back from six-week highs after Trump's decision to impose tariffs on steel and aluminum took the wind out of the greenback's week-long recovery.
The dollar index against a basket of six major currencies fell nearly half a percent to 89.925.
Trump announced on Thursday that he would impose heavy tariffs on imported steel and aluminum to protect U.S. producers, risking retaliation from major trade partners such as China, Europe and Canada.
Bilal Hafeez, a macro strategist at Nomura in London, said Trump's move was much more aggressive than tariffs his most recent predecessors.
Barack Obama imposed tariffs on Chinese steel imports in May 2016 and George W. Bush against EU steel imports in March 2002. Those moves saw the dollar fall 1.5 percent and 6 percent respectively in the subsequent months.
"The contours of the dollar reaction will likely depend on the reaction of other countries to these tariffs... The more powerful force could be the withdrawal of capital flows to the U.S.," he wrote in a note.
BOJ's Kuroda comments also threw some cold water on the short yen trade that has gained momentum in recent months.
"Kuroda comments overnight hint at a departure from stimulative policy and what is also interesting is that yen buying over the last few weeks seems to have been coming out of Japan itself, rather than from overseas investors closing carry trade positions so this move could still accelerate," said John Marley, head of FX strategy at Infinity International, a currency risk management firm.
Short yen positions, at $12.62 billion, are near record levels hit in early 2014 as investors have bet that monetary policy divergence between the U.S. central bank and the Bank of Japan will increase over time.
Investors have also used a cheap yen in recent years as a borrowing currency to fund carry-trades in other markets and a rising yen could unwind some of those positions.
The greenback was nearly 0.5 percent lower at 105.75 yen after touching 105.70 earlier, its lowest since Feb. 16. Against the euro and sterling, the yen was 0.3 and 0.5 percent higher respectively.
But some such as Marc Ostwald, global strategist at ADM Investor Services warned against reading too much into Kuroda's comments noting that any withdrawal will be "very very tricky" given their huge footprint in the bond and the stock markets.
"This is testing the water to try and formulate an exit strategy, but certainly not an indication that an exit will start anytime soon," Ostwald said.
Speculation about when the BOJ, which has significantly lagged its peers in moving towards policy normalization, would explore an exit from easy policy has been one of the key themes impacting the yen.
But investors were wary of kicking the dollar much lower, particularly against the euro and sterling, due to looming political developments.
The focus for the euro was on Sunday's Italian parliamentary election and the level of support for populist agendas that could have a wider impact on the European Union.
Also on Sunday, Germany's Social Democrats announce the result of a binding members' vote on a coalition deal that would secure Angela Merkel a fourth term as chancellor.
"Unless there is a big surprise over the weekend, we don't expect the euro to trade significantly weaker from these levels," said Manuel Oliveri, London-based FX strategist at Credit Agricole.
The single currency was up 0.4 percent at $1.23180.
British Prime Minister Theresa May will lay out her views on how to keep trade open between all of the United Kingdom and the European Union in a key speech at around 1330 GMT on Friday.
(Reporting by Saikat Chatterjee; Additional reporting by Shinichi Saoshiro in TOKYO; Editing by Kevin Liffey and Jon Boyle)