* Dollar trades near 14-year high
* European shares set 11-month high
* Two-year German bond yields reach record lows
By Atul Prakash
LONDON, Dec 16 (Reuters) - European stocks climbed to an 11-month high on merger and acquisition speculation on Friday, while the dollar's rally paused as investors adjusted their portfolios to cope with any faster-than-expected increases in U.S. interest rate.
World stocks as measured by the MSCI world equity index , which tracks shares in 46 countries, rose 0.18 percent. Japan's Nikkei gained 0.7 percent after rising to a one-year peak on the export prospects from a weaker yen.
Global financial markets have been choppy since the Fed's meeting on Wednesday, when it raised rates for the first time in a year and projected three more rate increases for the United States next year. The dollar has since strengthened to almost parity with the euro.
The dollar index, which tracks the U.S. currency against a basket of six other major currencies, stood at 102.970, or down 0.05 percent. It had risen to a 14-year high of 103.560 on Thursday, when it advanced 1.2 percent to record its biggest daily percentage gain in nearly six months.
European shares were 0.16 percent higher. Merger and acquisition speculation around drug maker Actelion and insurer Generali helped the benchmark index to set an 11-month high earlier in the session.
The euro zone's blue-chip Euro STOXX 50 index turned positive for the year after a two-week rally driven by a rebound in beaten-down banking shares.
Analysts and traders said that the European stock market's outlook remained broadly positive in the medium term, with major stock indexes likely to reach new highs.
"Stocks are continuing to get a boost from a weaker euro and the notion that the United States, the world's largest economy, will experience an uptick in growth once President-elect (Donald) Trump has started implementing his new policies," said Markus Huber, a trader at City of London Markets.
European infrastructure and commodities companies have been in demand since Trump pledged to invest in infrastructure projects. European banks have rallied on the positive dollar outlook.
The possibility of tighter Fed monetary policy also drove the benchmark U.S. Treasury 10-year yield to its highest in more than two years.
"Rising inflation and tightening monetary policy will prove tough for bonds in 2017, while cyclically-sensitive equity sectors should benefit from improving economic growth," said Luca Paolini, chief strategist at Pictet Asset Management.
"Inflation-linked bonds are starting to look attractive again, while high-yield bonds, particularly U.S., merit greater caution."
In Europe, however, two-year German government bond yields dropped to record lows after the European Central Bank's recent tweaks to its asset-purchase programme.
Earlier this month, the ECB said it would reconfigure its bond-buying scheme at the start of 2017, introducing changes that suggested it would focus its purchases on the short end of euro zone government bonds.
In commodities, a stronger dollar and signs of mounting supply in London Metal Exchange warehouses dragged copper prices lower. Other industrial metals also slipped.
Oil prices stabilised as evidence rose that producers in the Middle East were informing customers of upcoming supply cuts as part of a coordinated effort to drain a global glut.
Asian stocks were tepid, with MSCI's broadest index of Asia-Pacific shares outside Japan down 0.1 percent, after falling 1.8 percent on Thursday.
For Reuters new 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 (Additional reporting by Abhinav Ramnarayan in London and Shinichi Saoshiro in Tokyo Editing by Larry King)