* Yen rallies broadly on prospect Japanese pension funds

will invest more domestically

* Dollar index up slightly on the week

* Iran tensions muddy inflation outlook

(Updates to afternoon New York trading)

By Chuck Mikolajczak

NEW YORK, July 10 (Reuters) - The yen strengthened on Friday

and was poised for its biggest daily percentage gain in more

than a week after Japan said it plans to encourage pension funds

to increase their holdings of domestic financial assets.

Japanese Finance Minister Satsuki Katayama said the government

was pursuing measures that would include encouraging the

Government Pension Investment Fund, the world's largest pension

fund, to make "substantially greater investments in Japanese

financial assets."

The Japanese yen strengthened 0.44% against the

greenback to 161.67 per dollar after reaching 161.26. However,

the dollar was still up about 0.2% on the week against the yen.

"If you look at the scope or scale of the move, it's not

that impressive - it went from, it was a one yen move, and it's

retraced partially already. So it's like, all right, when are we

gonna talk seriously about the matter?" said Eugene Epstein,

head of trading and structured products at Moneycorp in

Stamford, Connecticut.

"At this point, it's still just, it's an urging, it's not an

official directive, and frankly, they could just be testing the

waters ... this is a good step, so let's actually maybe put

something firm here and then see how the markets react further."

BROAD-BASED YEN RALLY

The rally was broad-based, with the euro and British

pound down around 0.5% each against the Japanese

currency.

Before Friday's news, the yen had been holding near 40-year

lows, keeping traders on watch for potential intervention by

Japanese authorities.

"We have argued that macro impulses clearly are pushing

towards further Yen weakening, but meaningful repatriation flows

- if they occur - could be one of the most credible of several

paths that lead to the Yen eroding its severe undervaluation,"

said Goldman Sachs analysts in a note.

The dollar was roughly unchanged on the day, with the dollar

index, which measures the greenback against a basket of

currencies, edging up 0.03% to 100.94. For the week, the dollar

was up about 0.1%.

The euro was down 0.11% at $1.1416 while sterling

slipped 0.06% at $1.3397 after climbing to $1.3451, its highest

since June 15.

The European Central Bank is back to square one in its fight

against high inflation in the euro zone after new hostilities

between the U.S. and Iran caused energy prices to rise again,

ECB policymaker Yannis Stournaras said.

WAR CLOUDS SENTIMENT

Investors also monitored tensions in the Middle East, where

a new flareup of hostilities this week between the U.S. and Iran

has renewed concerns for the outlook of energy prices and global

inflation, and the impact on policy for global central banks.

Daily tanker traffic in the Strait of Hormuz, the critical

waterway,appeared to have slowed on Friday.

U.S. President Donald Trump said that Iran had asked to continue

talks and the U.S. had agreed, but that the June ceasefire was

"over".

U.S. crude fell 1.15% to $71.23 a barrel and Brent

dipped to $75.81 per barrel, down 0.64% on the day as

Iran's semi-official Tasnim news agency reported a Qatari

delegation visited Iran on Friday in what is believed to be an

effort by Doha to consolidate its role as a mediator.

Still, the recent escalation in hostilities put crude prices on

track for a weekly gain as supply worries were exacerbated.