(Reuters) -The euro was on track for its biggest monthly fall since January as political uncertainty weighed in the run up to France's general elections, while the dollar jumped to a near four-decade high against the battered yen ahead of key inflation data.

Investors fear that a new French government could increase fiscal spending, threatening the sustainability of the country's public debt and the financial stability of the bloc.

At the same time, traders are cautiously testing Japan's determination to protect its currency while keeping a keen eye on crucial U.S. inflation data.

The euro was down 0.05% at $1.0695, and set to end the month with a 1.33% drop, the biggest since January, when it fell by 1.99%.

The risk premium investors demand to hold French government bonds rose to its highest since 2012 on Friday ahead of the first round of voting this weekend in the country's parliamentary elections, as investors expect a new government led by a far-right or far-left coalition to increase fiscal spending.

"The markets remain priced for a relatively benign scenario of a gridlocked legislature or a Rassemblement Nationale (RN) government, which only partially implements its manifesto," said Aman Bansal, director of European rate strategy at Citi.

He added that the yield spread between French and German government bond yields - a gauge of French debt risk premium - now at 84 bps, could widen to 135 bps if the far right or the far left implements most of their manifesto and President Emanuel Macron resigns.

"Our euro zone team suspects it will be too early for a new government to substantially water down its pre-election pledges and that it may well be a rocky few months into September," said Chris Turner, head of forex strategy at ING.

The yen hit 161.27 per dollar, its weakest since 1986.

"Dollar-yen is very much U.S.-interest rate driven," said Rong Ren Goh, a portfolio manager in the fixed income team at Eastspring Investments in Singapore.

"If the intent is to stall severe yen depreciation, they might also want to save bullets for occasion when and if U.S. Treasury yields stage another rally in the second half, which is highly possible against the backdrop of Treasury supply and fiscal deficit issues," he added.

U.S. PRESIDENTIAL DEBATE

Republican U.S. presidential candidate Donald Trump unleashed a barrage of at-times false attacks on President Joe Biden in their first campaign debate in Atlanta, with the dollar rising as Biden stumbled over his words a few times in early exchanges.

"Biden came across poorly," said Jason Wong, market strategist at BNZ in Wellington.

That increased the odds of a Trump presidency and import tariffs, he said, noting traders were buying dollars but moves were fairly modest.

The dollar index equalled Wednesday's eight-week high of 106.13 and has logged a 1.5% rise for the quarter so far.

It is the second quarterly gain in a row as markets have trimmed expectations for U.S. rate cuts over the past six months. The Federal Reserve's preferred inflation measure, the personal consumption expenditures (PCE) index, is due later on Friday. If its annual growth slowed to 2.6% in May, as economists expect, it may open the way to cuts later this year.

The quarter's biggest loser has been the yen, down 6% on the dollar since the end of March and more than 12% in 2024 so far.

At 172.38 per euro it touched a record low on the common currency early on Friday. Core inflation in Japan's capital accelerated in June, data showed on Friday, though that did little to support the yen.

Low Japanese interest rates have encouraged selling yen for higher-yielding currencies even as Japanese yields have started to rise and officials have warned of another round of currency intervention.

Japan replaced top currency diplomat Masato Kanda on Friday with financial regulation expert Atsushi Mimura. Finance Minister Shunichi Suzuki said authorities were "deeply concerned" about the impact of "rapid and one-sided" yen moves.

(Reporting by Tom Westbrook, Stefano Rebaudo and Vidya Ranganathan; Editing by Jacqueline Wong, Jamie Freed and Muralikumar Anantharaman)