By Tommy Wilkes
LONDON (Reuters) - The euro fell on Tuesday, heading towards a 3-1/2 month low as weaker-than-expected economic data at the start of the week dented euro zone sentiment ahead of the U.S. Federal Reserve's policy decision.
The dollar has rallied in the last fortnight, helped by the 10-year Treasury yield topping 3 percent and a reconnection between higher interest rates and a buoyant currency.
While markets don't expect a change in interest rates from the U.S. Federal Reserve at the conclusion of a meeting on Wednesday, analysts will be watching for any change in language.
BNY Mellon strategists said in a note that if the Fed drops any cautionary comments on its inflationary outlook, then it would signal a growing confidence among policymakers that inflation has firmed up enough for an increase in forecasts.
Bond markets are expecting roughly three rate hikes until the end of the year.
That, combined with growing doubts about when the European Central Bank will move to slow its stimulus as the economy shows signs of peaking, have knocked the single currency lower.
The euro fell 0.2 percent to $1.2058 <EUR=>, not far from the $1.2055 it hit at the end of last week, the weakest level since mid-January.
The dollar rose 0.1 percent against a basket of currencies to 91.964 <.DXY>.
Markets are also focused on Friday's April U.S. non-farm payrolls report, which could provide further signs of strength in the world's biggest economy.
The greenback had risen 2 percent in April, its biggest monthly gain since November 2016, after the U.S. 10-year Treasury yield <US10YT=RR> climbed above the psychologically significant 3.0 percent threshold to four-year highs last week.
The U.S. currency received its latest lift after the euro slumped on soft German March retail sales data.
"The euro's downturn is expected to continue in the near term amid receding prospects of the ECB embarking on monetary tightening," said Masafumi Yamamoto, chief forex strategist at Mizuho Securities in Tokyo.
"With such themes weighing on its peers, the dollar looks well supported against the euro and pound, even without help from higher Treasury yields."
European markets are closed on Tuesday for a public holiday.
The dollar was a shade higher at 109.43 yen <JPY=>.
The greenback climbed to a 2-1/2-month high of 109.540 yen on Friday as long-term U.S. yields rose. But it has lost momentum as Treasury yields have pulled back from four-year peaks.
The Australian dollar traded flat <AUD=D3> after dropping to $0.7525 on Monday, its lowest since Dec. 12.
The currency showed little response to the Reserve Bank of Australia's well anticipated decision on Tuesday to leave its cash rate unchanged at 1.50 percent.
Currencies such as the Australian and the New Zealand dollar, which previously enjoyed the support of relatively high interest rates, have declined as their yield advantages have been eroded, particularly against the dollar.
The New Zealand dollar extended its decline to touch $0.7029 <NZD=D4>, its lowest since Dec. 27. The kiwi fell nearly 3 percent in April.
(Graphic: World FX rates in 2018 http://tmsnrt.rs/2egbfVh)
(Additional reporting by Shinichi Saoshiro in TOKYO; Editing by Andrew Heavens)