Aug. 10 (Bloomberg) -- The dollar rebounded from a two-month low against the euro before a report tomorrow that may show U.S. retail sales surged last month.

The statistics may help the dollar by damping speculation the Federal Reserve is done raising interest rates. The central bank this week left its benchmark rate unchanged at 5.25 percent, ending a run of 17 straight increases since June 2004.

``There's been chatter in the market that perhaps the Fed might prove to be more vigilant in the face of inflation risks,'' said Sophia Drossos, chief currency strategist at Morgan Stanley in New York ``We've definitely seen a paring of short dollar positions,'' which are bets the currency will fall.

The U.S. currency strengthened to $1.2795 per euro at 5:02 p.m. in New York, from $1.2862 late yesterday, for its biggest gain since July 17. It earlier reached $1.2912, the weakest since June 6. It was little changed at 115.27 yen from 115.36, after earlier falling as low as 114.68 yen.

Retail sales probably rose 0.9 percent in July after a 0.1 percent drop in June, according to the median forecast in a Bloomberg News survey before tomorrow's government report.

The dollar briefly fell against the euro and Swiss franc earlier after the U.S. raised its security threat level following a foiled overnight plot to blow up airliners traveling from Britain.

`Leg Up'

Traders were betting the dollar would fall this week after the Fed met on Aug. 8, and have been disappointed that it didn't extended losses beyond $1.29, said Russell LaScala, head of spot foreign-exchange trading in New York at Deutsche Bank AG.

``The risk is tomorrow we get a strong number'' in the retail sales report, said LaScala. ``It may give the impetus for another leg up for the dollar.''

The U.S. currency has lost 7.4 percent against the euro and 2 percent versus the yen this year on speculation the Fed will stop raising rates as central banks in Europe and Japan continue lifting their benchmarks.

``Some inflation risks remain,'' the Fed said in a statement on Aug. 8 when it left the target rate unchanged. It added that any further rate boosts depend on the outlook for inflation and growth.

A government report on Aug. 16 is forecast to show a measure on inflation at the highest in a decade.

Consumer Prices

Consumer prices, excluding food and energy, probably rose 2.8 percent in July from a year earlier, the highest since March 1996, according to the median estimate of economists surveyed by Bloomberg.

Interest-rate futures show traders see a 27 percent likelihood the Fed will lift the overnight lending rate between banks to 5.5 percent at its meeting on Sept. 20, down from 71 percent two days ago. Futures reflect a 56 percent chance of a Fed increase to 5.5 percent by year-end. That's up from 53 percent yesterday, though still down from 96 percent last week.

The dollar also strengthened after a government report today showed the U.S. trade deficit narrowed in June.

The trade gap, the amount by which imports exceed exports, narrowed to $64.8 billion in June from $65 billion in May, the government said. It fell short of the record shortfall of $66.6 billion in October, and compared with the median forecast of a $64.5 billion deficit in a Bloomberg survey.

Traders ``may have been positioned for a much worse reading,'' said Alex Beuzelin, a senior currency analyst at Ruesch International Inc. in Washington. ``It may be a little bit of a relief bump up.''

Yuan Speculation

The yen advanced to 147.46 per euro, rebounding from a record low of 148.60 reached earlier, amid speculation it would benefit from a stronger Chinese currency. China reported a record trade surplus a day after its central bank said it would allow faster appreciation in the yuan to reduce exports and increase imports.

The yuan was at 7.9710 against the dollar, for a 1.7 percent gain since China revalued the currency in July 2005 and ended a decade-old peg to the dollar.

``There is some speculation about Asian currency appreciation that is helping the yen,'' said Naomi Fink, senior currency strategist at BNP Paribas Securities in New York.

A stronger yuan makes Chinese goods more expensive abroad relative to those from Japan. It also helps lower the cost of imports for consumers in China, Japan's largest trading partner.

China's central bank allows the yuan to rise or fall as much as 0.3 percent from a daily reference rate. The currency has never moved that much in a single day.

To contact the reporter on this story: Michael McDonald in New York at mmcdonald10@bloomberg.net; Deborah Finestone in New York at dfinestone@bloomberg.net.

Last Updated: August 10, 2006 17:04 EDT