* Dollar weakens after last week’s rally
* Euro pauses below $1.23
* All eyes on U.S. inflation data due on Wednesday
* Stock market bounce seen supporting high-yielding FX
* Graphic: World FX rates in 2018 tmsnrt.rs/2egbfVh
By Tommy Wilkes
LONDON, Feb 12 (Reuters) - The euro edged higher on Monday and the dollar fell back, as a strong start to the week for equity markets ended a rally for the greenback.
The dollar last week had its best performance against the euro since November 2016 as a brutal sell-off across asset classes forced investors betting against the U.S. currency to unwind their positions. The dollar also benefited as nervous investors bought the relative safety of some U.S. assets.
On Monday, the dollar’s rally came to an end as the euro staged a fightback.
Appetite for risk-taking crept back into currency markets to the detriment of the U.S. currency - it also helped higher-yielding emerging market currencies as well as commodity-linked currencies like the Australian and Canadian dollars.
The dollar was down 0.2 percent against a basket of currencies, erasing some of the gains last week.
European shares rallied on Monday after Asian markets had found a semblance of calm.
The sell-off last week spilled over into currencies, forcing many traders to exit higher yielding but riskier currencies and seek safety in the Japanese yen and Swiss franc.
One of the most popular trades of the year has been to buy euros, betting that the European Central Bank would tighten monetary policy faster than expected.
“We have a little bit of risk appetite back into the market,” said Nordea Markets currency strategist Niels Christensen, adding that the U.S. consumer price inflation numbers due on Wednesday would be the decisive data for dollar direction this week.
“The market is still extremely long positioned on the euro. These investors will be quick to reduce their positions,” he said.
The euro was up 0.1 percent at $1.2270 after earlier hitting a day’s high of $1.2298. The euro suffered its worst week since November 2016 last week and remains almost three cents off its three year high of $1.2538 hit in January.
The moves in foreign exchange markets were far more muted than in other asset classes last week, but analysts said volatility had risen.
Commerzbank said worries about U.S. inflation returning were reflected in rising exchange rate volatilities options markets. Analysts at the bank said that inflation concerns were unlikely to disappear quickly, and that investors should get used to FX volatility “remaining at higher levels for now or even rising further.”
The Australian dollar rose 0.2 percent to 78.33 cents , after last week hitting its lowest level since December. The Canadian dollar gained 0.1 percent as the dollar weakened.
Against the yen, the dollar also eased but it paused above a five-month low.
The dollar fell 0.1 percent to 108.68 yen, remaining above Friday’s trough of 108.05 yen, its lowest level since Sept. 11. The dollar last week fell nearly 1.3 percent against the yen.
The yen tends to attract demand in times of market stress as the currency is backed by Japan’s current account surplus.
The Swiss franc added 0.1 percent against the euro, but it was below the highs of last week.
For Reuters Live Markets blog on European and UK stock markets see reuters://realtime/verb=Open/url=http://emea1.apps.cp.extranet.thomsonreuters.biz/cms/?pageId=livemarkets (Editing by Andrew Heavens)