FOREX-Dollar gains, cheered by U.S. jobs report

* Dollar rises; U.S. payrolls drop smaller than expected

* Dollar index posts biggest 1-day gain in over 5 months

* Euro/dollar has worst day in six weeks

* UK political uncertainty slams sterling (Updates prices, adds details)

By Gertrude Chavez-Dreyfuss

NEW YORK, June 5 (Reuters) - The dollar on Friday posted its largest one-day gain against a basket of currencies in more than five months after data showed the United States shed fewer jobs than expected in May, boosting hopes for an economic recovery.

The dollar initially sold off after the jobs report, which showed the U.S. economy shed 345,000 jobs, well below the 520,000 expected by economists. In the past, the dollar had fallen in response to data hinting at improvement in the U.S. economy, with investors moving into riskier assets, including higher-yielding currencies.

For story on the jobs report click on [ID:nN05274048].

But the U.S. currency rebounded after initial losses, as investors started to focus on brightening U.S. economic fundamentals.

"The first 'knee-jerk' reaction was the old 'risk-positive is dollar-negative' response," said Alan Ruskin, chief international strategist at RBS Global Banking and Markets in Greenwich, Connecticut.

"The second thought was that the U.S. was leading the positive risk response and accordingly should not be penalized. The latter logic works on the basis that a recovery is good news for the dollar's main Achilles heel -- fiscal financing."

In late afternoon trading, the ICE Futures' dollar index, a gauge of the greenback's value against a basket of six currencies, rose to 80.725 .DXY, up 1.6 percent, its best performance Dec. 19, according to Reuters data.

The dollar index was up 1.8 percent this week, its largest weekly rise since April 12.

The euro fell to $1.3963, down 1.6 percent on the day, its worst showing in about six weeks. It earlier fell to a one-week low on electronic trading platform EBS at $1.3932 EUR=EBS after a knee-jerk jump to $1.4269 after the data.

The dollar rose to nearly one-month highs at 98.90 yen on EBS. It last traded at 98.88 JPY=EBS, up 2.4 percent.

"Today seems to be the first day in a while where the dollar is responding positively to positive U.S. news," said said Marc Chandler, senior currency strategist at Brown Brothers Harriman. "That has wrong-footed people."

Sterling was down 1.2 percent against the dollar at $1.5982 GBP=D4, according to Reuters data, after hitting a one-week low of $1.5940.

The euro was down 0.6 percent at 87.42 pence EURGBP=D4 after rising to 88.67 pence, a roughly three-week peak.

British Prime Minister Gordon Brown averted the immediate danger of government collapse on Friday with a cabinet reshuffle that bought the loyalty of key ministers, but the political uncertainty weighed on sterling. [ID:nL5061759]

By backing down from replacing finance minister Alistair Darling, Brown appeared to have headed off an open revolt by his Labour party for now. But his authority has been wounded at a time when Britain is in its deepest recession in 60 years and markets and the country are looking for strong government.

Such concerns fed into a market already positioned to take the pound lower after a steep rally in the past few weeks.

The dollar also gained 1.7 percent against the Swiss franc to 1.0859 francs CHF=EBS on EBS, the biggest one-day advance since May 15. Earlier, the dollar rose to 1.0908 francs, its highest since May 28. (Additional reporting by Nick Olivari; Editing by James Dalgleish)