FOREX-Dollar hits 3-mth peak vs yen on U.S. rate outlook

By Rika Otsuka

TOKYO, May 23 (Reuters) - The dollar hit a three-month peak against the yen and hovered around a six-week high against the euro on Wednesday, supported by shrinking expectations that the Federal Reserve will cut interest rates later this year.

Comments from a top Fed official backed the market's view that the U.S. central bank is not in a hurry to lower the funds rate from the current 5.25 percent.

Richmond Federal Reserve Bank President Jeffrey Lacker said on Tuesday that the best contribution the U.S. central bank can make for growth is to keep inflation low and stable, and markets likely understand the Fed will not tolerate higher inflation.

Dealers further trimmed short dollar positions ahead of U.S. economic data, including durable goods orders and new home sales on Thursday and existing home sales on Friday, that could give more clues on the future path of the Fed's monetary policy.

"Market players keep buying back the dollar," said a trader at a Japanese bank. "Where the dollar is going this week all depends on upcoming U.S. data."

A series of solid economic data last week gave the dollar a respite from a sell-off that pushed it to a record low versus the euro late last month, cooling expectations for a Fed rate cut this year.

The dollar rose as high as 121.73 yen JPY= on electronic trading platform EBS on Wednesday, its highest since Feb. 13.

Market participants are now focusing on whether the pair will climb beyond 122.20 yen, the highest since December 2002 and this year's peak struck in late January.

The euro barely budged against the dollar, trading at $1.3455 EUR=. It fell to a six-week trough of $1.3436 on EBS on Monday.

Against the yen, the single currency was up 0.2 percent at 163.80 yen EURJPY=R, remaining within striking distance of a record peak of 163.94 yen hit on Monday.

Strong figures in the ZEW survey of German investor confidence, which reinforced expectations the European Central Bank will raise interest rates to 4 percent from a current 3.75 percent in June, failed to boost the euro on Tuesday as speculators kept reducing their long euro positions.

Long euro positions -- bets that it will rise -- have accumulated to a record high this month, making market players careful about buying the single currency.

But investors still believe the downward trend in the euro since the currency hit a record high against the dollar in late April may be reversed after dealers lighten their long euro positions to a level they can feel comfortable with again.

"The market knows how strong the euro zone economy is and continues to expect a ECB rate hike in June," said Masaki Fukui, a senior market economist at Mizuho Corporate Bank. "The market is likely to turn bullish on the euro again," Fukui said.

U.S.-CHINA TALK CONTIUNES

Traders were watching for any comments from the United States and China as a two-day meeting between Treasury Secretary Henry Paulson and Chinese Vice Premier Wu Yi concludes in Washington on Wednesday.

A senior Bush administration official said on Tuesday that U.S. and Chinese officials had a "direct exchange of views" on the valuation of the yuan currency, with the U.S. side saying China still needed to allow the yuan to appreciate more rapidly.

The United States argues that an undervalued yuan CNY= gives China an unfair advantage in international trade and is a key driver of the deficit.

Last week, China's central bank widened the yuan's daily trading band against the dollar to 0.5 percent from 0.3 percent.

The market has been showing a calm reaction to the U.S.-China talks so far, as investors do not expect China to yield further on the currency policy issue than last week's step. (Additional reporting by Satomi Noguchi)