* 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 morning New York trading)

By Chuck Mikolajczak

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

was on track 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 0.38% against the

greenback to 161.77 per dollar after reaching 161.27. However,

the dollar was still up about 3% 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 0.4% 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.

"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 0.01% to 100.92. For the week, the dollar

was up about 0.1%.

The euro was down 0.06% at $1.142 while sterling

was little changed, up 0.01% at $1.3407 after climbing to

$1.3451, its highest since June 15.

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 appeared to

have slowed on Friday, with both sides still arguing over who

was in control of passage through the critical waterway.

U.S. crude fell 0.55% to $71.67 a barrel and Brent

fell to $76.10 per barrel, down 0.25% 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.