* Euro up 0.25 pct vs USD, 0.5 pct higher vs JPY
* Italy budget compromise hopes, UK/EU deal lift sentiment
* Graphic: World FX rates in 2018 tmsnrt.rs/2egbfVh
By Dhara Ranasinghe
LONDON, Nov 26 (Reuters) - The euro advanced towards a two-week high on Monday as risk appetite picked up thanks to firmer oil prices, and news that Italy may cut its budget deficit target to placate the European Union.
Developments in Italy and news that Britain and the EU sealed a Brexit deal helped the single currency overcome disappointing German business sentiment data.
Sterling firmed nearly a third of a percent to $1.2880 after Sunday’s Brexit pact, but the currency’s gains were curbed by doubts about Prime Minister Theresa May getting the agreement through a divided parliament.
Europe’s single currency gained almost a third of a percent to $1.1368 and was up 0.5 percent at 128.65 yen . It hit a two-week high of $1.1472 last week.
European stock markets rallied over 1 percent, while the gap between Italian and German government bond yields was at its tightest in almost two months on signs that Rome was preparing to rework its spending plans.
Italy may reduce next year’s budget deficit target to as low as 2 percent of gross domestic product to avoid a disciplinary procedure from Brussels, two government sources said on Monday.
“The dominant driver is what’s happening in Italy and there is some hope there that there will be some tweaking of the budget deficit lower,” said Derek Halpenny, European head of global markets research at MUFG in London.
“That’s clearly been a factor in terms of what’s been undermining the euro from a spread basis — if you’re getting selling of Italian bonds, a lot of that flow is going into German bonds and depressing the spread over the United States.”
As risk assets rallied, U.S. stock futures were up more than a percent, while the dollar index dipped 0.2 percent to 96.73.
Broader optimism over the euro was also reflected in the latest weekly positioning data, where long dollar positions have been declining slightly for the week ending Nov. 16. Net weekly positions in the euro rose by their biggest weekly margin in more than two months for that week.
“Abating political risk in Europe could help all European currencies today,” said Valentin Marinov, head of FX research at Credit Agricole in London.
Marinov added, however, that most major currencies were likely to remain in a holding pattern ahead of key risk events later this week, which include a speech by the U.S. Federal Reserve Chairman Jerome Powell and the G20 meeting.
At a G20 meeting in Buenos Aires on Nov. 30, U.S. President Donald Trump and Chinese President Xi Jinping are expected to discuss contentious trade matters which would have an impact on currencies such as the Australian and New Zealand dollars which have close trading ties with China.
In another sign of improved risk appetite, the Japanese yen changed hands at 113.18, down by a fifth of a percent against the greenback, while the Australian dollar was half a percent firmer at $0.7261 and away from last week’s low at $0.7202.
Currency markets showed little immediate reaction to news that the German Ifo business climate index dipped in November.
Focus turned instead to an appearance by European Central Bank chief Mario Draghi at the European Parliament later this session.
Bank of Japan Governor Haruhiko Kuroda meanwhile said on Monday he was confident the central bank can shrink its balance sheet at an appropriate pace when it exits ultra-loose monetary policy.
Elsewhere, a recovery in oil prices boosted the Norwegian crown, which was trading 0.5 percent higher at 8.55 crowns per dollar.
Reporting by Dhara Ranasinghe; Additional reporting by Saikat Chatterjee Editing by Robin Pomeroy