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LONDON, Oct 2 (Reuters) The yen hit a 5-1/2 month low against the dollar and slipped versus the euro on Monday as an above-forecast ''tankan'' survey of business sentiment failed to change expectations of gradual rises in Japanese interest rates.

The euro held broadly steady after a closely-watched survey showed euro zone manufacturing growth held firm in September, keeping expectations intact the European Central Bank would raise interest rates this week to 3.25 percent.

Japanese stocks rallied and bonds fell after the tankan's headline diffusion index of confidence at big manufacturers rose to a two-year high of plus 24 in September, contrary to expectations for an unchanged reading from the plus 21 in June.

''The story is that in the long-term context Japanese institutions are raising their exposure to overseas assets and reducing hedging on (these) positions. So a better economic picture is leading investors in Japan to take more risks,'' said Adam Cole, currency strategist at RBC Capital Markets.

''So the good news seems to be the bad news for the yen. (The euro zone PMI) is consistent with what we've seen from national surveys. A 25 basis points rate hike is pretty much guaranteed this week and it will take an awful lot to change this.'' By 0815 GMT the yen stood at 118.24 per dollar having fallen to the low of 118.39 earlier. The yen was also slightly down at 149.91 per euro. The euro was steady at $1.2674.

LOW YIELDING STATUS The yen's failure to hold gains highlighted the market's distaste for the low-yielding currency, even as the data kept the BOJ on track to raise rates in the first quarter next year at the latest and beyond.

With benchmark rates at just 0.25 percent, the BOJ has some way to go in raising rates before investors are lured back to the yen.

In the quarterly tankan, confidence was seen falling to plus 21 in December, but analysts said that overall the survey underscored Japan's steady recovery from deflation.

Big firms said they planned to boost capital spending by 11.5 percent in the current business year, below expectations for a 11.7 percent increase but still solid. Major non-manufacturers felt the biggest need to hire workers in 14 years.

The euro zone purchasing managers index came in at 56.6 in September, unchanged from a month ago. The price components of the survey were higher.

US RATES From the United States, the release of the September ISM manufacturing survey kicks off a week packed with key data which would give clues whether the next move in the Federal Reserve would be an interest rate cut.

The ISM index is seen slipping to 53.5 from 54.5 the previous month, which would still indicate a moderate expansion.

Upbeat economic data last week, including a report showing a pick-up in Midwest business activity, helped to soothe worries about a sharp slowdown in U.S. growth.

Friday brings a closely-watched employment report for September.

The Reserve Bank of Australia and Bank of England are also due to meet this week.

Reuters CS ND1422