* Euro near 2-month high, some signs of overheating
* Dollar broadly weak ahead of FOMC
* Fall in U.S. yields undermines dollar
* Pound licks wounds after surprisingly weak UK GDP
By Hideyuki Sano
TOKYO, Jan 26 (Reuters) - The dollar held near a 10-week low
against a basket of currencies on Wednesday, with the market
looking for confirmation from the Federal Reserve later in the
day that its focus remains on supporting growth.
The perception that the Fed will keep a much easier policy
than the European Central Bank, which is growing worried about
inflation, has helped the euro to extend its recovery after a
two-month drubbing from worries over euro zone debt.
The dollar extended losses for a fourth day, after U.S. bond
yields fell on news of President Barack Obama's proposal to
freeze portions of federal spending in his State of Union
address.
"U.S. bond yields fell yesterday so I'm not sure how much
further they are going to fall after the FOMC. But, on the whole,
sentiment for the dollar seems weak," said a trader at a Japanese
bank.
The dollar index against a basket of major currencies dipped
to 77.864 <.DXY> <=USD>, just a hair above a 10-week low of
77.814 hit earlier in the week.
Analysts expect the U.S. central bank will keep short-term
rates near zero and will say it remains committed to its $600
billion bond purchase programme, known as QE2.
That stands in stark contrast with the ECB. Governor
Jean-Claude Trichet has warned about rising inflation in the
region, sparking speculation that the ECB may raise rates later
this year and helping to widen the euro's rate advantage over the
dollar.
In the interest rate swap market, the spread between two-year
rates in the two currencies jumped to 110 basis points --
approaching a two year high and up sharply from 73 basis points
just three weeks ago.
The euro also benefited from strong demand for the inaugural
bonds from Europe's financial rescue fund on Tuesday.
PROFIT-TAKING
Asian investors, including the Japanese government, took up
more than one-third of the 5 billion euro ($6.84 billion) offer,
although the Japanese government has said it would use euro cash
in its foreign currency reserves to buy the bonds.
The euro stood at $1.3685 <EUR=>, near a two-month high of
$1.3705 hit on Tuesday and within sight of a 61.8 percent
retracement of its November-January fall, around $1.3740.
Beyond that, its Nov. 22 high of $1.3786 is seen as a major
target.
"It doesn't seem like there are stretched euro long positions
in the market. I see more upside for the euro," said another
Japanese bank trader.
But some oscillators such as the slow stochastic and the
14-day RSI signal the currency might be overbought in the near
term, pointing to a possible setback after a strong 6 percent
gain in little more than two weeks.
Some market players suspect the Fed's policy meeting could
provide a good pretext for profit-taking in the euro, which
several analysts see as inevitable.
Since hitting a four-month low of $1.2860 on Jan. 10, the
euro has posted substantial losses only one day and is due for a
correction, said Masato Chin, president of Chin Associates.
Chin added that the euro was likely to rebound, however, and
head for $1.40, with the dollar set to fall after the formation
of a clear double top on the dollar index chart over the past few
months.
"The dollar index will inevitably fall to around 76. It's a
textbook case of a double top," Chin said.
The British pound recouped early losses but remained shaky
after an unexpected contraction in the UK economy in the fourth
quarter prompted investors to scale back expectations of a rate
hike by the Bank of England.
The pound fetched $1.5822 <GBP=D4>, flat on the day. It had
fallen as low as $1.5750 on Tuesday.
Against the resurgent euro, the pound was near a 2-1/2-month
low of 0.86695 per euro hit on Tuesday <EURGBP=D4>. It last
traded at 0.8652.
The dollar slipped about 0.2 percent against the yen to 82.05
yen <JPY=>, not far from last week's two-week low of 81.85 yen.
Traders say bids below 82 yen are likely to support the
dollar for now. It also has trendline support around 81.20.
Still, it has fallen below the bottom of the daily ichimoku
cloud, now at 82.36, which is considered as a major bear signal.
($1=.7311 Euro)
(Additional reporting by Ayai Tomisawa; Editing by Edmund
Klamann)
