* FTSE 100 down 0.5 pct
* Yellen comments on valuations take toll on equity markets
* Weak German investor morale also hurts sentiment
* Imperial Tobacco down, to buy Reynolds/Lorillard brands
* Housebuilders fall, UK inflation takes surprise jump
By Tricia Wright
LONDON, July 15 (Reuters) - Britain's top shares lost ground on Tuesday after U.S. Federal Reserve Chair Janet Yellen voiced concern over valuations. Housebuilders were hit by growing expectations UK interest rates will soon rise, while Imperial Tobacco fell sharply.
In the monetary policy report accompanying her Congressional testimony, Yellen said, "equity valuations of smaller firms as well as social media and biotechnology firms appear to be stretched."
In the United States, the Russell 2000 small-cap index lost more than 1 percent and the Global X Social Media ETF shed almost 2 percent.
The UK's FTSE 100 closed down 35.69 points, or 0.5 percent, at 6,710.45 points as the comments from Yellen prompted closer scrutiny of valuations more broadly. The index was also hurt by German investor morale data, which dropped to its lowest in 1 1/2 years in July.
Imperial Tobacco sank 3.7 percent, making it the top FTSE 100 decliner, following news that Reynolds American would buy rival Lorillard and sell brands to the British cigarette maker to address antitrust issues.
Reynolds said it would sell its Kool, Salem and Winston and Lorillard's Maverick and blu eCigs brands and other assets to Imperial Tobacco for $7.1 billion in cash.
Following the announcement concerning the brand and asset disposals, credit rating agency Fitch revised its outlook on Imperial Tobacco to negative from stable.
"Fitch views positively the enlargement of Imperial's U.S. operations but at the same time notes that failure to enhance the cash flow generation and profit growth capability of its core European business would seriously impair credit metrics," Fitch said.
Shares in housebuilders, volatile in recent weeks, came under pressure as a report on Tuesday showed British inflation unexpectedly rose to a five-month high in June.
Barratt Developments fell 2.2 percent. Mid-caps Redrow and Taylor Wimpey fell by 3.7 percent and 2.9 percent respectively.
"The feeling seems to be that interest rates could potentially go up sooner than the market expects, given the way that the inflation data was reported," said Manoj Ladwa, head of trading at TJM Partners.
Housebuilders sold off in mid-June when Bank of England Governor Mark Carney said rates may rise sooner than markets were predicting. They recovered towards the end of the month when the BoE imposed measures aimed at curbing house prices that turned out to be more lenient than the builders had feared.
Carney said on Tuesday the central bank's forward guidance was intended to signal how interest rates might change over the medium term, not pinpoint the timing of a first hike. (Reporting by Tricia Wright; Editing by Catherine Evans)