* Dollar up vs yen after US data, BOJ asset purchase plan
* Yen weakens as risk sentiment improves tentatively
* Improvement in German sentiment index lifts euro
* Investors await end of Fed policy meeting on Wednesday (Updates prices, adds detail)
By Steven C. Johnson
NEW YORK, March 17 (Reuters) - The dollar rose against the yen on Tuesday as surprisingly strong U.S. housing data whetted risk appetite and plans by the Bank of Japan to buy subordinated loans raised fears the central bank would flood the market with yen.
The euro also rose above 128 yen, just shy of its highest level this year, and gained against the dollar, lifted partly by data showing improvement in German investor sentiment.
"The BOJ move overnight weighed on the yen and we've seen some relatively robust moves in equities," said Mark Frey, head of FX trading at Custom House in Victoria, British Columbia.
"But a lot of currencies are starting to run out of gas, as we've seen a moderate rally in risk for six days and now we need some fresh impetus to drive us from here," he said.
Fresh impetus could come at the end of the Federal Reserve's two-day policy meeting on Wednesday, particularly if the U.S. central bank, which has cut benchmark interest rates to zero, announces plans to buy long-dated Treasuries to keep long-term rates low.
"The Fed decision is restraining the market. Nobody is stepping into any big positions ahead of it," Frey said.
The dollar was last up 0.4 percent at 98.55 yen <JPY=> while the euro rose 0.8 percent to 128.30 yen <EURJPY=>, near its 2009 high around 128.74 yen, according to Reuters data.
Yen selling picked up after the Bank of Japan said it would buy up to 1 trillion yen ($10.2 billion) in subordinated bank loans to bolster the banks' depleted capital.[ID:nT322335]
That sparked fear the BOJ will flood the market with yen, putting downward pressure on a currency already struggling amid worries about the deteriorating Japanese economy.
The euro rose above $1.30 for a second straight day, last trading up 0.4 percent at $1.3018 <EUR=> as Wall Street rallied. Sterling dipped 0.1 percent to $1.4045 <GBP=>.
The dollar tends to rally when investors become risk averse because it's seen as the safest store of value at time when economies across the globe are contracting. Its role as a main funding currency outside Europe also enhances its appeal.
When sentiment improves, however, investors feel more confident buying stocks and other major currencies, while the pressure to hoard dollars for funding needs eases.
BOJ RESCUE, AWAITING THE FED
Bank of Japan governor Masaaki Shirakawa said in a press conference that the loan program was aimed at banks being hurt by falling stock prices. [ID:nTKU103306].
The Bank of Japan is seen keeping interest rates steady at 0.10 percent on Wednesday but could increase its outright buying of government bonds.
Overall, though, risk appetite was holding up, thanks partly to a 22.2 percent surge in U.S. housing starts in February and a gain in German investor sentiment.
A report showing U.S. producer prices actually edged higher in February, easing some concern about deflation, also lifted spirits. [ID:nN17421065]
Analysts said euro gains were capped, however, ahead of the end of the Fed policy meeting on Wednesday, when the Fed will issue a policy statement.
The euro "looks likely to chop sideways as we wait for the Federal Reserve and in particular any color on whether they are closer to buying Treasuries," Alan Ruskin, chief international strategist, at RBS Greenwich Capital in Greenwich, Connecticut, said in a note.
(Additional reporting by Vivianne Rodrigues; Editing by Leslie Adler)