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Euro on track for biggest monthly fall since January

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Yen hits weakest since 1986 vs dollar; new low vs euro

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Dollar spikes during US presidential debate

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Focus on US PCE index due later on Friday

(Recasts lead, adds comments, background)

By Stefano Rebaudo and Tom Westbrook

June 28 (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.