FOREX-Weak yields prod dollar towards 6-1/2 month low

* Dollar index heads back towards 6-1/2 month lows

* Expectations for June Fed rate hike bounce

* But 10-year yields flat to lower, keeping pressure on greenback

* Sterling dips marginally after Manchester attack

* Graphic: World FX rates in 2017

By Patrick Graham

LONDON, May 23 (Reuters) - The dollar dipped against the basket of currencies that measures its broader strength on Tuesday, low 10-year U.S. Treasury yields underlining the collapse of faith in a promised boost to growth and inflation from the Trump administration.

Moves in the major currencies were tight, but the common denominator was a broadly weaker dollar, down 0.2 percent against the yen, the euro and as much as half a percent against a resurgent New Zealand dollar.

“The 10-year Treasury yield is down 2 basis points and that is feeding through to the dollar underperforming,” said Sam Lynton-Brown, a currency strategist with BNP Paribas in London.

“The market was positioned very short of the kiwi so there has been a bit of a squeeze there. Dollar-yen (also) hasn’t adjusted lower in terms of what we are seeing in the yields and there is a risk for a correction towards 110 yen.”

By 0735 GMT, the dollar index was down 0.2 percent on the day at 96.820, just off a 6-1/2 month low of 96.797 hit mid-session on Monday.

It traded at 111.18 yen and $1.1257 per euro, having traded at $1.1268 - its weakest since Trump’s election last November.

The euro was strengthened on Monday by comments from German leader Angela Merkel, who said a euro that was “too weak” was the cause of Germany’s massive trade surplus.

Berlin is likely to hear more grumbling, particularly from a Washington administration that has made noises about the dollar’s strength, at a meeting of Group of Seven leaders in Italy this weekend.

But it is a fall off in U.S. data and growing concern over a White House that has failed so far to deliver on grand promises on border taxes, spending and capital repatriation that have dominated the past fortnight.

The dollar is now down around 7 percent for this year, handing back all of its gains after Trump’s election last year.

“While the ebb in French political risk and prospects of a ECB policy shift have helped the euro, the biggest support factor still remains the recent weakening of the dollar in wake of ‘Russiagate,’” said Junichi Ishikawa, senior FX strategist at IG Securities in Tokyo.

“Merkel’s comments was extra fuel for the euro ... that said, a weaker dollar is not necessarily a bad thing for Trump.”

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