Dollar falls against euro as ECB decision approaches

NEW YORK (Reuters) - The dollar fell against the euro and was little changed against the yen on Tuesday in a volatile session as investors debated the outlook for the U.S. economy while anticipating a rate hike from the European Central Bank later this week.

The European Central Bank is widely expected to raise interest rates by a quarter percentage point to 4.25 percent on Thursday, bolstering demand for euro-denominated assets and euros to buy them with.

The yen had climbed broadly in early trading on Tuesday, benefiting from mounting risk aversion as heightened fears of further losses in the banking sector and global stocks prompted investors to sell dollars.

But U.S. stocks retraced earlier losses after General Motors GM.N reported stronger-than-expected June sales, keeping the dollar off session lows. A rise in U.S. factory activity also helped the dollar.

"It's rangebound behavior in anticipation of the ECB rate hike," said Michael Woolfolk, senior currency strategist at The Bank of New York Mellon. "People are looking for an excuse to buy euros and sell dollars."

In late New York trading, the euro changed hands 0.2 percent higher against the dollar at $1.5783 EUR=.

The European currency pared some gains against the greenback after the Institute for Supply Management said its index of national factory activity rose in June to 50.2 from 49.6 in May after four straight months of contraction.

"The ISM index climbed back into growth territory and should ease some of the concerns about the outlook for the U.S. economy that had pressured the dollar overnight," said Joe Manimbo, a currency trader at Ruesch International in Washington.

In Europe, data showed euro zone manufacturing activity contracted for the first time in three years in June and output prices matched April's year high. But analysts said Tuesday's data will not prevent the ECB raising rates.

Yen gains against the dollar were limited as demand for the greenback rose after the ISM report.

The dollar last traded near flat at 106.10 yen JPY=, but well off the session low of 105.24 yen, while the euro gained 0.2 percent to 167.47 yen EURJPY=R.

Markets have begun to take the view that the Federal Reserve has little scope to tighten U.S. monetary policy aggressively to fight inflation given the sluggish economy.

The greenback traded 0.1 percent lower against a basket of major currencies .DXY at 72.369, starting the third quarter on the back foot.

The ISM report "should firm up the dollar a bit because one thing that's been going on over the last few days is the market is growing doubtful about the possibility of Fed rate hikes for the rest of the year," said Boris Schlossberg, a senior currency strategist at DailyFX.com, in New York.

"But if we see employment in dire straits and core job losses going forward, the Fed will find itself in the worst possible position -- between high inflation rates and slow growth. It will be like a deer frozen in headlights," he added.

The yen had gained broadly overnight with risk aversion in currency markets stoked by a slide in global stocks. The yen tends to garner support in times of heightened risk aversion as investors reverse trades financed by borrowing the Japanese currency at low interest rates.

(Additional reporting by Steven Johnson; editing by Gary Crosse)

(Reporting by Nick Olivari and Vivianne Rodrigues)