* Dollar index down from two-month peak
* Solid U.S. jobs data keep December taper view alive
* Diverging Fed/ECB policy path expected to mute euro
By Gertrude Chavez-Dreyfuss
NEW YORK, Nov 11 (Reuters) - The dollar fell on Monday after a two-day rise against the euro as investors locked in gains, but its prospects remained upbeat on expectations the Federal Reserve might scale back its stimulus program sooner than thought following a strong U.S. jobs report.
A U.S. government holiday on Monday kept many investors on the sidelines and volumes low. While the euro managed to recoup some of its losses, analysts cautioned against reading too much into Monday’s trading.
The overall expectation is for the dollar to perform favourably against the euro following a shock interest-rate cut from the European Central Bank, and a blockbuster U.S. jobs number last week. That robust employment figure has everybody talking about a December reduction in the Fed’s bond buying, which should be positive for the greenback because it means there would be fewer dollars in the financial system.
“Actual or expected tapering will be positive for the dollar. Further delays of tapering will alter the path but not the ultimate level of the dollar: higher than here,” said Stephen Jen, co-founder of London-based investment firm SLJ Macro Partners.
The euro rose to $1.3416 on lower-than-usual volumes, but gains were capped as investors began to sell from around $1.3400 through to $1.3410. The euro hit a two-month low of $1.3295 last Thursday after the ECB cut its main interest rate to a record low 0.25 percent.
The euro-zone currency was last trading up 0.3 percent at $1.3414.
“We think this latest bounce in the euro is setting up potentially good opportunities to enter new shorts against the dollar and sterling, and against the higher-yielding commodity bloc currencies,” said Vassili Serebriakov, currency strategist, at BNP Paribas in New York.
Against the yen, the dollar gained 0.1 percent to 99.19 yen.
The dollar index slipped 0.3 percent to 81.061 after setting a two-month high at 81.482 following Friday’s report showing U.S. employers added 204,000 jobs in October - well above the forecast for an increase of 125,000 jobs.
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 for 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 momentum 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, according to 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.