Yen buoyed by data, oil weighs on stocks

LONDON, Sept 5 (Reuters) European stocks fell on Tuesday as oil crawled back above a barrel, while the Japanese yen extended gains against the dollar on economic optimism ahead of a Bank of Japan policy meeting later this week.

Bond markets extended losses as investors continued to book profits on Friday's rally, sparked by soft U.S. housing data.

European shares slipped from near four-month highs, pulled lower by technology and retail stocks, but analysts said equity losses should be short-lived given that crude was still hovering at its lowest in over three months.

''One big positive for stocks right now should be the fact that oil prices have been coming down quite sharply over the last week and the fact that we've made a technical break through a barrel,'' said David Brown, chief European economist at Bear Stearns.

''That should be an important (factor) for stocks down the road because lower oil prices are going to be less of a drag on growth going forward and the further oil prices fall, the more positive effect it is going to have on inflation expectations.'' The FTSEurofirst 300 index of top European shares was 0.4 percent lower at 1,377.88 points, while electronic trading of U.S. light sweet crude futures was at .45 a barrel.

YEN RALLIES Dealers started unwinding extreme short yen positions after data showing a rise in Japanese capital spending on Monday rekindled speculation that the central bank there might raise rates this year despite a run of soft economic data last month.

''The story there is the follow-through from the capital business investment figures that came out early yesterday suggesting the economy is not as weak as expected, as markets had been predicting during the course of August,'' said Kevin Grice, senior economist at American Express Bank.

''Because the market was heavily short yen, those shorts got squeezed and we're just working that through.'' The Bank of Japan decides on interest rates this Friday and its post-decision conference will be closely watched.

The BOJ raised key rates to 0.25 percent for the first time in six years in July, but since then it has stressed that future increases will come only gradually.

This comes at a time when soft U.S. data especially in the housing sector has reinforced expectations that the Fed will refrain from hiking rates for now.

The dollar traded down a quarter percent on the day against the yen at 115.88 yen.

BOND WOES With speculation rife that the Fed will remain on hold in the near future, a report by the Organisation for Economic Cooperation and Development saying the Fed may need to raise interest rates weighed on bonds.

Euro zone government bonds had already weakened in early trade, as investors cashed in on Friday's rally and awaited the return of U.S. players after a public holiday on Monday.

At around 1215 GMT, the benchmark September Bund future was down 20 ticks on the day at 118.16.

Adding to bonds' woes, euro zone data left intact expectations for more European Central Bank rate hikes.

Euro zone services growth slowed more than expected in August to its weakest pace since January but price rises persisted.

The prices charged index was barely changed at 53.6 compared with 53.7, while the gauge of input prices dipped only slightly to 59.9 from 60.2, which economists said showed inflationary concerns remain. Retail sales in the euro zone also came in much stronger than expected in July.

The European Central Bank is widely expected to raise rates twice more in coming months to reach 3.5 percent by year-end, according to Reuters polls.

REUTERS PKS KN1944