FOREX-Euro's rally takes a pause on brewing political worries
* Euro falls on profit-taking, political worries, Spain data
* Euro still favoured but market cautious before ECB meeting
* Dollar rises to fresh 2-1/2 year high against yen
* Expectations of more easing keep pressure on yen
By Anooja Debnath
LONDON, Feb 4 (Reuters) - The euro retreated from multi-month highs against the yen and dollar on Monday as speculators took profit on the common currency's rally and caution set in before the European Central Bank meets this week.
Weak Spanish unemployment data, a lower-than-expected improvement in the euro zone sentiment index and political uncertainty in Italy and Spain all dragged the common currency lower.
Spanish bond yields rose sharply on news Spain's prime minister Mariano Rajoy was facing increasing calls to resign on corruption charges. Polls showing Italy's former prime minister Silvio Berlusconi regaining ground before elections later this month added to investor concerns.
But the euro's dip was likely to prove temporary, strategists said, and it would resume its move up if the ECB expressed no concern about the currency's recent gains at a news conference after its interest rate decision on Thursday.
"We have had a strong run, we are still bullish (on the euro) over the next few weeks but this week could be a week of consolidation. We see a bit of profit taking ahead of the ECB meeting," said Kiran Kowshik, currency strategist at BNP Paribas.
"There is also a little bit of uncertainty around Italian and Spanish politics, weighing on the euro."
The euro traded at $1.3560, down 0.6 percent on the day, having hit a session low of $1.3556, as some speculators trimmed recent bets in favour of the euro. It fell past stop loss orders below $1.3570 with more stops cited below $1.3550.
The euro had risen to $1.3710 on Friday, a level unseen since late 2011 and up more 3 percent so far this year.
Against the yen, the euro was down 0.6 percent at 125.98 yen , off a 33-month high of 126.97 yen struck last week.
Analysts said the euro would be bought at lower levels against the dollar and yen in coming days as interest rate differentials move in favour of the shared currency.
One reason for the euro's outperformance has been the ECB's relatively upbeat view on the euro zone economy. It has been the only major central bank to withdraw some of its unconventional monetary stimulus while the Bank of Japan, the U.S. Federal Reserve are all expanding their balance sheets.
Monetary stimulus or balance sheet expansion usually hurts a currency as it increases its supply.
"Once the ECB fails to cut rates on Thursday, which is our view, the euro will be free to move higher again, but with the uncertainty surrounding the meeting the euro will likely weaken slightly or trade sideways," said Adam Myers, senior FX strategist at Credit Agricole.
Data last Friday showed currency speculators added to bets in favour of the euro in the week ended Jan. 29. They also increased their bets against the yen while they lowered some of their short positions against the dollar.
The dollar touched a fresh 2-1/2 year high of 93.185 yen, breaking through reported options barriers at 93.0 yen. More barriers were reported at 93.25 yen and 93.50 yen.
"The yen will remain weak, though it will likely not be sold at the momentum seen last week," said Myers, who added that investors would be looking to buy the euro and dollar against the yen on dips.
Sentiment towards the yen is negative as the BOJ is expected to remain under pressure to ease policy aggressively.
Analysts said Japanese portfolio managers were also looking to review their allocations after the change in monetary policy, and that could prompt more outflows from Japan and weigh on the yen.
"A reduction in the high level of JGB (Japanese Government Bonds) exposure traditionally held by Japanese funds will have both short-term and long-term negative effects on the yen, in our view," analysts at Morgan Stanley said in a note.
"We maintain our dollar/yen long position."
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