* Dollar pressured against the yen, support at Jan. 1 low of 86.53 yen
* Japan government to buy bonds issued by ESM
* French Finance Ministry dismisses rumors of downgrade
* US earnings announcements could sway currency market sentiment
By Julie Haviv
NEW YORK, Jan 8 The dollar and the euro dropped against the yen on Tuesday as investors felt the time was ripe to book profits in the aftermath of swift and significant gains linked to predictions of more aggressive Bank of Japan action.
The dollar has rallied smartly against the yen for over a month on expectations that Japan's newly elected government would push the Bank of Japan, headed by Governor Masaaki Shirakawa, to adopt more forceful monetary stimulus measures.
However, after notching an impressive 5.2 percent gain in December and a 0.5 percent increase since the start of the year, the dollar fell for a second straight session.
"There is a lot of profit taking going on and people decided to pare back positions after they reached overstretched levels," said Daniel Hwang, chief currency strategist at Gallant Capital Markets in New York.
"Action from the Bank of Japan seems to be sufficiently priced in and when it comes down to it, the move higher in the dollar and euro against the yen was just too far and too fast," he said.
The dollar fell to a session low of 86.95 yen after a rally of nearly 12 percent in recent months that saw the dollar touch its highest level since July 2010.
It was last down 0.7 percent at 87.18 yen, with solid support expected at around 86.53, the low hit on Jan. 1.
Analysts said investors were nervous of pushing the yen too much lower due to the risk the BOJ may not opt for aggressive stimulus as early as its next meeting on Jan. 21-22, with a focus on Shirakawa's tenure at the helm of the Japanese central bank.
"We still have Shirakawa, who is not leaving until the end of March, so there is a risk of disappointment," said Chris Turner, head of FX strategy at ING in London.
The euro initially gained against the yen after Japanese Finance Minister Taro Aso said the government would buy bonds issued by the European Stability Mechanism, the euro zone's permanent bailout fund.
The euro, however, eventually dropped against the yen because while Japan buying ESM bonds is supportive for Europe, the country holds mostly dollars and euros in reserves, which makes its weakening impact on the yen unclear.
The euro was last down 1 percent on the day at 114.04 yen, having hit a session high of 115.21 after Aso's comments.
"Japan's comments helped euro and dollar/yen a bit higher at first. But then everyone realized they are just going to use current reserves so there should actually be no impact," said Geoff Kendrick, FX strategist at Nomura, of the market reaction to the plans to buy ESM bonds.
EURO FALLS AHEAD OF ECB MEETING
Markets are positioned for the European Central Bank to keep rates on hold when it meets this Thursday. The euro zone common currency was volatile on market talk that France's sovereign debt rating would be imminently downgraded but the impact was fleeting. A French Finance Ministry spokeswoman on her Twitter feed called the rumors "unfounded and false."
With no significant economic data this week, the euro was seen staying in a range ahead of the ECB meeting and Spanish and Italian bond auctions toward the end of the week.
However, any hint by ECB policymakers about future interest rate cuts could undermine the currency.
"Markets have backed away from peripheral issues in Europe for now, and unless we start to get broader concerns, euro/dollar will continue to trade sideways for now," said Geoff Kendrick, FX strategist at Nomura in London.
Currency trading activity could also be swayed by the U.S. earnings season, which is expected to show sluggish growth in quarterly corporate profits.
Corporate profits are expected to be higher than the third quarter's lackluster results, but analysts' estimates are down sharply from where they were in October.
The euro fell against the dollar for the first time in three sessions but held above a three-week low of $1.2997 set on Friday. Profit taking in the yen crosses impacted the currency pair.
The euro was last down 0.2 percent on the day against the dollar at $1.3084, according to Reuters data.