* Euro near 7-1/2-month peak vs dollar * Scope for year-end demand to test March high near $1.34 * Yen vulnerable to easing expectations By Gertrude Chavez-Dreyfuss NEW YORK, Dec 18 (Reuters) - The euro hovered near a 7-1/2-month high against the dollar on Tuesday on signs of progress in U.S. budget talks and generally improving investor sentiment on euro zone assets. Market players sold the safe-haven dollar on optimism U.S. policymakers can reach a deal to avoid the so-called "fiscal cliff," a combination of tax hikes and spending cuts that risks tipping the world's largest economy into recession. According to a source, President Barack Obama was open to tax rate increases beginning at incomes above $400,000 instead of his previous proposal of $250,000. "There is some relief that budget negotiations in the U.S. appear to be progressing," said Camilla Sutton, chief currency strategist at Scotia Capital in Toronto. "The market views progress as positive. Most expect that the U.S. fiscal drag will equate to between 1 and 2 percentage points off the 2013 GDP, therefore avoiding the most severe outcome." The improvement in market sentiment lifted the euro and also boosted demand for European shares while pushing Spanish and Italian bond yields lower. Some strategists said year-end investment flows could help the euro extend its gains to test the late-March high just below $1.34, although concerns about the euro zone's weak growth outlook may leave it vulnerable to selling in the new year. The euro was last up 0.1 percent on the day at $1.31808, near a 7-1/2 month high of $1.3191 hit on Monday. The dollar index slipped to a two-month low of 79.606. If U.S. policymakers do reach a compromise before steep tax hikes and spending cuts kick in early next year, strategists said currencies that tend to gain on a better global growth outlook - like the euro and Australian dollar - should benefit. The Swedish crown rose against the euro to 8.7080 per euro after the Riksbank cut its repo rate by 25 basis points as expected but said rates would remain on hold for some time. The outlook wrongfooted some investors who had positioned for a hint of further cuts in future. The euro was last down 0.4 percent at 8.7279 crowns. BOJ IN FOCUS The yen slipped against the euro, with the single currency rising 0.2 percent on the day to 110.66 yen, within sight of a nine-month high of 111.30 yen hit on Monday. The Japanese currency tumbled after the Liberal Democratic Party surged back to power in an election on Sunday, fuelling expectations the new government will drive the Bank of Japan towards more aggressive monetary easing. The dollar was up 0.1 percent at 83.98 yen, having hit a high of 84.48 yen on Monday, its strongest level since April 2011. Traders cited option barriers at 84.50 yen with stop-loss buy orders above that level. "We are in a situation where we will see the government tell the central bank what to do. Such a politicised situation is never good for a currency, and the yen will weaken," said Peter Kinsella, currency strategist at Commerzbank. "Apart from the politics, the economic data from Japan has not been good. This should see quite aggressive easing from the BOJ. We are forecasting 90 yen over the coming year." Some analysts said there was scope for the dollar to come under pressure and the yen to edge higher in the near term if the BoJ disappoints those expecting more aggressive monetary easing after a two-day policy meeting ends on Thursday. Speculators have sold the yen on expectations the BoJ could adopt a more aggressive asset buying programme. But sources familiar with the BOJ's thinking have said the most likely option is for the central bank to increase its asset-buying and lending programme, currently at 91 trillion yen, by another 5-10 trillion yen. That would fall short of expectations and could lead to some of the large short yen positions being cut.