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LONDON, Aug 7 (Reuters) The dollar held near a two-month low against a basket of currencies on Monday after soft U.S. jobs data hardened expectations that the Federal Reserve would pause its two-year-old tightening cycle this week.

In a market driven by yield differentials and the outlook for future interest rates, the yen came under pressure as expectations grew the Bank of Japan would leave interest rates steady this week and for some time after hiking last month.

''The market has mostly priced out a 25 basis point rate hike from the Fed and judging by the tone of (Fed officials) it will be a surprise if they did not pause,'' said David Simmonds, head of FX strategy at Royal Bank of Scotland.

''Over the next quarters the yen will get interest rate support but it will be a long haul. The yen will remain an attractive funding currency.'' By 1130 GMT the dollar was steady at $1.2860 per euro, having hit a two-month low of around $1.2909 on Friday.

The dollar index held at 84.68, near Friday's two-month low of 84.39. The dollar was up 0.5 percent at 114.95 yen, while the euro rose to a one-week high of 147.89 yen.

Sterling hit an 8-1/2 month high of 67.31 pence per euro and rallied to 8-year peaks of 219.36 yen.

FED PAUSE? Data on Friday showed U.S. non-farm payrolls grew less than expected in July, prompting investors to conclude the Fed would keep rates at 5.25 percent on Tuesday after 17 straight rises.

U.S. rate futures put the chances of an 18th tightening at just 16 percent late on Friday, while 17 out of 22 U.S. primary dealers polled by Reuters predicted the Fed would hold off.

''The worst-case, short-term USD scenario Tuesday is a pause and relatively dovish language. In our view, a pause with slightly more hawkish language, may not be enough to prevent kneejerk USD selling,'' JP Morgan said in a note to clients.

''Our view is that the Fed will tighten again in December of this year to 5.50 percent (and tighten more in 2007); the market expects only a rate of approximately 5.33 percent by year-end,'' the bank said.

In the euro zone, the European Central Bank is set to continue raising interest rates. After upping them by 25 basis points last week, investors are increasingly betting on a 25 basis point rate hike in October.

ECB Executive Board member Lorenzo Bini Smaghi told Italian newspaper Il Sole 24 Ore that euro zone rates were still ''very accommodating'' even after a rise to 3.0 percent last week and the process of adjusting policy would continue.

ECB Governing Council member Klaus Liebscher told Bloomberg TV that if the bank's economic scenario is confirmed, ''a further withdrawal of what is still an accommodating monetary policy is naturally required''.

REUTERS SBA RN2120