FOREX-Euro advances as euro zone prospects brighten; Fed looms

* Euro hits highest since December 2011, just below $1.35

* Yen moves further away from 2-1/2-year low vs dollar

* Fed meeting, U.S. GDP, January payrolls due this week

By Gertrude Chavez-Dreyfuss

NEW YORK, Jan 29 (Reuters) - The euro scaled 14-month peaks against the dollar on Tuesday, gaining in three of the last four sessions, boosted by a more upbeat euro zone outlook and expectations the Federal Reserve will keep its ultra-easy monetary policy for some time.

German economic data and signs European banks may have turned the corner bolstered hopes that the worst of the euro zone's crisis has passed, boosting the euro 2 percent against the dollar so far this year.

The euro had earlier rallied to just below $1.35, a key resistance and psychologically important level. Analysts expect the level eventually to be breached, which would open the door to a rise toward $1.3835.

The focus has also been on the Fed's monetary policy committee, which started the first of its two-day gathering on Tuesday. Investors expect a continuation of quantitative easing beyond this year, a negative for the dollar as it expands the currency's supply.

"The expectation is that the Fed will continue to pump money into the financial system and while that's good news for the stock market, that's bad news for the dollar," said Chris Gaffney, co-chief investment officer at Everbank Wealth Management, in St. Louis, Missouri.

"In contrast, we have the European Central Bank moving to take away some of those stimulus and effectively, it is on a tightening path. That has been the difference."

The euro rose as high as $1.3497, the highest since Dec. 2, 2011. It last traded up 0.3 percent at $1.3493. The slight increase in a German consumer confidence indicator to 5.8 heading into February from 5.7 the previous month helped the euro as well, as the data was consistent with the trend of improving sentiment surveys in the euro zone's largest economy.

Brian Kim, currency strategist at RBS Securities in Stamford, Connecticut, said overall economic data out of the euro zone showed mixed results.

"There is no crazy outperformance in the euro zone, but what we're seeing is an unwinding of positions based on expectations of deposit rates going lower. People in general are still rising this wave of optimism on the euro," said Kim.

Analysts at ActionForex.com said the euro's intraday bias is back on the upside and sustained trading above $1.3486 will extend the whole rally to key resistance at $1.3790. They added that as long as the $1.3264 support holds, the near-term outlook should stay bullish.

Action Economics said proprietary names and an Asian central bank are looking to sell near $1.3500, however. Defense of the $1.3500 option barrier may also limit the momentum.

INVESTORS UNWIND LONG BUNDS TRADE

Douglas Borthwick, managing director at Chapdelaine Foreign Exchange in New York, said investors are beginning to feel more comfortable about long positions on the euro.

"German yields rising should be seen as a good thing in Europe. It represents an unwinding of the long Germany, short everything else in Europe trade," he said. He added that the euro will continue to rise as long as the two-year euro currency basis swaps, a measure of funding conditions in the euro zone, continue to tighten.

The euro briefly rose and hit a session high after data showed U.S. consumer confidence dropped in January to its lowest level in more than a year.

Aside from the Fed, investors are also looking out for the first estimate of U.S. fourth-quarter GDP due on Wednesday, two days before the January jobs report. Weak readings on the U.S. economy could add to expectations of continued monetary easing by the Fed and weigh on the dollar.

The dollar dropped against the yen, slipping further away from a 2-1/2-year high hit a day earlier. But analysts said yen weakness will resume as investors look to buy the dollar back at lower levels.

The dollar slipped 0.2 percent to 90.64 yen, down from Monday's high of 91.25 yen, its strongest level since June 2010. Traders reported options barriers at 91.50 and 92 yen.

The euro edged up 0.2 percent to 122.45 yen.

Selling the yen has been mostly a one-way bet since mid-November, based on expectations that Japanese Prime Minister Shinzo Abe would push the Bank of Japan into more aggressive monetary easing to beat deflation.

Present BOJ Governor Masaaki Shirakawa, whose term ends in April, is expected to be replaced with a more dovish governor, who could then bring forward any easing, giving further impetus to yen bears.