April 30, 2014 / 12:20 PM / 3 years ago

FOREX-Euro recovers after inflation dip fails to impress

* Euro back on front foot after inflation dips just slightly

* Yuan weakens, dealers eye implications for euro

* Fed policy also in focus (Adds new quotes, updates prices)

By Patrick Graham

LONDON, April 30 (Reuters) - The euro gained ground on Wednesday after April inflation failed to provide the strong support for a further easing of euro zone monetary policy hinted at by German numbers a day earlier.

The debate over the scale of disinflation in Europe has dominated major currency markets this week, and lower than expected April price growth of 0.7 percent initially sent the euro to a three-week low against the dollar.

But the undershoot was less than some had speculated after a below-expectation rise in Germany on Tuesday and was not seen as enough to force the European Central Bank to act immediately to pump more money into a struggling economy.

That, together with strong support for the euro above a large option expiry at $1.3750 discouraged efforts to push the euro lower.

"After the German figures yesterday, there was a lot in the price and this is not enough to drive us much further," said one London-based dealer after the data.

After hitting the three-week low of $1.37705, the euro recovered to trade almost 0.3 percent higher at $1.3852, nearing technical levels at which it failed on Monday and within shouting distance of this year's highs above $1.39.

Against sterling it hit its weakest in two months at 81.955 pence, before recovering in similar style.

Still, concern continues to grow over the outlook for inflation in the euro zone, reflected in regular efforts by the European Central Bank over the past month to rein in any further gains for the euro.

CHINA FALLOUT

One additional factor pointed to by some economists is the weakness of the Chinese yuan, which fell to an 18-month low at one point on Wednesday.

"Europe imports an awful lot of consumer goods from China and other Asian economies, and if we see a weaker Asian currency bloc then that will lead to the import of more disinflation (into the euro zone)," said Paul Robson, strategist with RBS in London.

He underlined that it was not just in the euro zone itself that inflation looked low, with other economies in mainland Europe suffering and some signs that core inflation - more reflective of underlying demand - was becoming a bigger factor. The drop in inflation so far has been driven substantially by lower food and fuel prices, over which policymakers have little control.

"I'm not sure if the read across on the weakness of inflation in Europe has been made, for example on sterling where it may put (downward) pressure on inflation and give the Bank of England room to push back rises in interest rates," Robson said.

The euro's strength against the dollar this year has been one of the big surprises for currency markets and seems broadly the result of Germany's large current account surplus and inflows of portfolio capital to European bond and stock markets.

But dealers also say the weakening of China's yuan has led to the People's Bank of China recycling some of the dollars it buys in the process into euros to rebalance its reserves.

"Every trader I know in London seems to be calling for a weaker euro. You can't find anyone who wants it higher, yet it does not want to fall," said a dealer with one London bank.

"At that point you just find yourself trading off a square book and waiting for a clearer trend to re-emerge."

In U.S. time, eyes will turn to the U.S. Federal Reserve's policy review due after Europe shuts down on Wednesday. The Fed is set to continue paring stimulus with a $10 billion taper to its monthly bond buying widely expected.

As for when the Fed will actually start lifting interest rates, traders said anyone seeking clarity on that front will be left sorely disappointed. (Editing by Alison Williams)

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