* Dollar index down from two-month peak
* Solid U.S. jobs data keeps December tapering view alive for now
* Diverging Fed/ECB policy path expected to mute euro
NEW YORK, Nov 11 (Reuters) - The dollar paused in its advance against the euro on Monday after two days of strong gains, with a further rise seen depending on whether U.S. bond yields keep rising amid an intensifying debate on when the Federal Reserve might scale back its stimulus.
But a U.S. government holiday on Monday kept many investors on the sidelines and volumes low. While the euro managed to retrace some of its recent losses, analysts cautioned against reading too much into Monday’s trading.
“It’s a very quiet day with more of a relief bounce” in the euro, said David Song, Currency Analyst at Daily in New York. “I think the euro could be in line for another move lower from here.”
The euro climbed to $1.3412 on lower-than-usual volumes, but gains were capped as investors began to sell it from around $1.3400 through to $1.3410. The euro hit a two-month low of $1.3295 last Thursday after the European Central Bank shocked the market with a surprise cut of its main interest rate to a record low 0.25 percent.
The euro zone currency was last trading up 0.3 percent at $1.3402. Against the Japanese yen, the dollar gained 0.1 percent to 99.20 yen.
“The dollar has come off slightly, but the defining factor is the rise in the U.S. yields,” said Jeremy Stretch, head of currency strategy at CIBC World Markets in London. “The dollar will be supported and for the euro any bounce toward $1.34 will be sold into.”
The dollar index dipped 0.2 percent to 81.108, after having set a two-month high at 81.482 after a report on Friday showed U.S. employers added 204,000 new jobs last month, well above the 125,000 new jobs forecast.
The data was even more surprising as it came in a month when a budget standoff in Washington forced a 16-day government shutdown, suggesting the U.S. economic recovery was on a firmer footing than previously thought.
As a result, U.S. Treasury yields rose, with the gap between two-year U.S. Treasuries and their German counterparts at its widest since mid-July. U.S. bond markets were shut on Monday and with yields rising quickly in the past week, some expect Treasuries to consolidate.
The benchmark 10-year U.S. Treasury note’s yield was also near a two-month high as some investors brought forward to December their expectations of when the Fed will start to withdraw its stimulus.
That underpinned the dollar as rising yields make a currency more attractive to hold. After the government shutdown, most had pushed back the Fed’s “tapering” expectations to March 2014.
Speculators have cut long euro positions and this trend could gather pace with the euro zone facing a prolonged period of slowing inflation. That could see the ECB deploying more aggressive monetary easing instruments.
“We think investors are caught long near $1.3450, with euro/dollar primed for a move toward $1.32 - a level euro zone and U.S. two-year yield differentials would point toward,” said Chris Turner, chief currency strategist at ING in London.
Just $2.89 billion in euros traded on Monday using Reuters Dealing data , making it the lowest-volume day for the euro since Oct. 21.
Although the ECB’s rate-setting committee was split about Thursday’s decision to cut rates, Executive Board member Benoit Coeure said on Saturday that the bank could trim interest rates further and provide more liquidity.