| NEW YORK
NEW YORK The dollar dropped against the euro and yen on Monday a day before a Federal Reserve policy meeting, but losses will likely be capped given expectations that the central bank will refrain from further policy easing given signs of a recovering jobs market.
The dollar touched a nearly seven-week high against a basket of currencies, but trade was choppy ahead of the Fed and U.S. retail sales data, a key monthly gauge given consumer spending comprises more than two-thirds of the economy.
With the majority of economists expecting the Fed to maintain its policy of keeping rates near zero through 2014 and refrain from mentioning a third round of bond buying, called quantitative easing, the retail sales data has the potential to sway currency sentiment.
U.S. retail sales data for February is expected to show a healthy 1 percent rise, which would follow last week's data showing a third straight month that U.S. employers added more than 200,000 jobs.
"A healthier labor market and stronger consumer spending will allow the Federal Reserve to save QE3 for a more desperate time in the global economy," said Kathy Lien, director of currency research at GFT Forex in Jersey City, New Jersey.
Lien said she expects USD/JPY to extend its gains and the EUR/USD to sell off further if the U.S. central bank acknowledges the improvements in the labor market and the increase in inflation.
"If for whatever reason the Fed places greater emphasis on the strains in the global economy and the downside risks, the dollar could give up its gains, but given how the U.S. economy has performed since January, we believe this is unlikely," Lien said.
The U.S. outlook contrasts with the euro zone where some countries are in a recession, so the euro should struggle in the coming weeks as relief over Greece's successful debt restructuring last week gives way to concerns over euro zone growth prospects and the risk of contagion.
The euro was last up 0.3 percent at $1.3148 after dipping to its lowest level since February 16. The session peak of $1.3156 was touched after the euro broke through minor technical resistance.
The dollar index rose to 80.132 .DXY, its highest since January 25, before slipping back to 79.870.
"Less QE in the U.S. is positive for the dollar," said RBS currency strategist Paul Robson in London. "In Europe the weakest data is in the countries with the weakest fiscal position, which is worrying, and it's still a case of selling euros on any rallies."
RBS expects the euro to fall to $1.26 over the next two to three months.
Euro zone crisis in graphics: r.reuters.com/hyb65p
U.S. jobs and presidencies: link.reuters.com/van96s
Last week Greece took final steps to restructure its debt, using legislation to force remaining private creditors to swap Greek debt for new bonds worth considerably less.
While that paved the way for a fresh round of bailout funds for Greece, there was little sign of relief in Spanish and Italian debt markets, where sovereign bond yields rose.
Another focal point for the market this week will be a policy decision by the Bank of Japan, also due on Tuesday.
The BOJ's monetary policy has been in the spotlight since its surprise easing in February. Most traders expected the BOJ to refrain from further easing though some saw a risk of action that would spark a sell-off in the yen.
The dollar slipped 0.2 percent against the yen to 82.24 yen as investors bet that this year's 6.8 percent advance in the greenback against the Japanese currency has been too far, too fast, particularly after touching a near 11-month high on Friday. U.S. bond yields rose on the upbeat jobs data, boosting the dollar's appeal versus the low-yielding yen.
The Australian dollar was down 0.7 percent at $1.0492 after China reported a $31.5 billion trade deficit, confounding forecasts of a $5 billion shortfall and raising concerns about the outlook for the world's second-largest economy.
(Additional reporting by Nick Olivari; Editing by James Dalgleish)