Risk appetite flickers as ECB bets hold down euro

LONDON (Reuters) - Risk appetite flickered back to life in financial markets on Tuesday with the dollar and European and Japanese shares rising while safe-haven bonds, the yen and gold all took a step back.

The dollar rose to its highest since January against the yen and the euro slipped to a one-year low after another drop in euro zone producer prices heightened speculation about what the ECB will do when it meets on Thursday.

U.S. stock indexes were marginally higher or steady as markets reopened after the long Labor Day weekend, with investors awaiting a flurry of manufacturing data.

Investors in Asia had been subdued, having been robbed of their usual U.S. lead-in overnight, but the mood in Europe had seemed brighter until fresh talk of sanctions on Russia and more soft producer prices data triggered a pullback.

As U.S. trading neared, European stocks <.FTEU3> <.FTSE> <.FCHI> were left battling to stay in the black, with only the Dax <.GDAXI> in Germany holding onto any real gains.

Ukraine said 15 of its soldiers had been killed in the past 24 hours in fighting with pro-Russian separatists backed by Russian troops, while Europe's next foreign policy chief said the bloc's leaders would decide on a package of new sanctions against Russia by Friday.

"We need to respond in the strongest possible way," Italy's Frederica Mogherini told reporters following a presentation to EU lawmakers in the European Parliament.

Russian shares <.MCX> and the rouble were broadly stable, though, after three days of falls. For those watching the developments closely, however, the lull was likely to prove temporary ahead of crisis talks at a NATO meeting in Wales at the end of the week.

"It is never a straight line, so it is a bit of a breather and a pause (in Ukraine-Russia tensions), but I continue to be concerned by this situation," said Benoit Anne, an emerging markets strategist at Societe Generale.

"And we all wait for the ECB, of course, this week. That is a major consideration and that will probably send a bullish signal to risky assets."

Bond markets have been one of the big beneficiaries of expectations the ECB will loosen policy to revive the euro zone's flagging economy, and traders cashed in some of those gains before Thursday's meeting even as the euro continued to edge south.

Comments by ECB President Mario Draghi late last month led to bets the central bank is preparing to pump more liquidity into the system, possibly via purchases of government or corporate bonds, a measure known as quantitative easing (QE), to boost the faltering euro zone economy and stave off the risk of deflation.

Sources from within the ECB told Reuters last week that new action at its meeting this Thursday was unlikely but not impossible, and the barrier to QE was still "very high".

Euro zone producer prices fell again last month, by 1.1 percent from a year ago, due to lower energy prices, data showed on Tuesday. It was the steepest annual drop since April, and the report caused the euro to tumble as low $1.3109 , after starting the session around $1.3123 .

IHS Global Insight economist Howard Archer said the price data was "more worrying news on the inflation front for the ECB," although core inflation, which strips out volatile elements like energy, has not dropped since November.

JAPAN REFORMS

In Asian trading, Chinese stocks gained for a third day and Tokyo's Nikkei <.N225> rose 1.2 percent, its biggest jump in almost a month. A planned cabinet reshuffle by Japanese Prime Minister Shinzo Abe helped to fuel reform hopes.

The dollar was boosted by the flagging euro and by gains in Tokyo shares that reduced demand for the safe-haven yen. The U.S. currency rose to a seven-month high of 104.87 yen and reached a 14-month high on the heavily traded <.DXY> index of currencies.

"This (the euro's trough) is not just about the ECB. Part of this is a dollar story ? the dollar has outperformed a whole bunch (of developed world currencies)," said Jane Foley, a senior currency strategist at Rabobank in London.

Foley added that increased momentum around the idea that the ECB would loosen policy, and that the Bank of Japan would introduce another round of QE, was driving the dollar's gains, with a perception that it was "the best of the bunch".

Later on Tuesday, an Institute of Supply Management report on the U.S. manufacturing sector could provide further evidence of economic improvement and highlight the diverging paths between the U.S. and euro zone economies. The U.S. Federal Reserve looks ready to phase out quantitative easing just as the ECB may consider introducing it.

Elsewhere, the Australian dollar showed little reaction to the Reserve Bank of Australia's widely expected decision to keep its cash rate at a record low 2.5 percent for the 12th consecutive meeting. The Aussie was down 0.5 percent at $0.9283 as it brushed a one-week low.

In commodities, Brent crude fell below $102 a barrel, pressured by worries about slowing oil demand growth in China and Europe, a strong U.S. dollar and ample supplies. [O/R]

Palladium cut back from the 13 1/2-year high of $910 an ounce it reached overnight on fears that Western sanctions will curtail supply from Russia, the world's biggest producer of the metal. Spot palladium last traded at $885 an ounce. Gold also nudged down as risk appetite recovered. [GOL/]

(Additional reporting by Shinichi Saoshiro in Tokyo; Editing by Larry King and Susan Fenton)