* Dollar index on track for biggest monthly fall since '85
* Rising risk appetite, U.S. deficit woes weigh on dollar
* U.S. economy contracted slightly less than thought
* Euro strikes a 2009 high against dollar (Updates prices, adds detail)
By Steven C. Johnson
NEW YORK, May 29 (Reuters) - The dollar hit a five-month low against a basket of major currencies on Friday and the euro rose above $1.41 for the first time this year as investors bought higher-yielding currencies and assets on hopes of a global economic recovery.
Sterling approached $1.62, almost an eight-month high, and capped its best month since 1985, while data showing the U.S. economy shrank less than expected in the first quarter lifted global stocks and dulled the dollar's safe-haven allure.
Concern about the expanding amount of debt needed to fund a record $1.8 trillion U.S. budget deficit added to dollar woes this week and put the benchmark 10-year Treasury yield en route to its biggest two-month spike since 2004.
Those worries amplified a report that South Korea's National Pension Service intends to reduce exposure to U.S. government bonds and equities in its five-year portfolio.
"There's a visceral concern about the debasement of the U.S. currency because the United States has a lot of debt to finance" and may have to print more money to do it, said Alan Ruskin, chief international strategist at RBS Greenwich Capital in Greenwich, Connecticut.
He said dollar weakness was driving up the price of oil, which is priced in dollars, and leading investors to bet that "emerging markets will lead the way to recovery." That lifted commodity currencies at the expense of the dollar and yen.
The euro peaked at $1.4168 <EUR=>, its best level since December, and last traded up 1.4 percent at $1.4137. Sterling rose 1.6 percent to $1.6169 <GBP=> after hitting $1.6199, its highest since early October.
The dollar also fell 1.7 percent to 95.25 yen <JPY=> while the Australian dollar rose above $0.8000 <AUD=> for the first time since September, leaving it on pace for a record monthly gain of more than 10 percent. The dollar fell 2.1 percent against its Canadian counterpart to C$1.0908 <CAD=>.
An index that measures the dollar against six major currencies .DXY fell 1.5 percent and suffered its worst month in May since March 1985.
HUNTING FOR YIELD
Government data showing the U.S. economy contracted slightly less than initially estimated in the first quarter encouraged investors to take on more risk.
"Money is flowing out of the dollar," said Jessica Hoversen, fixed income and currency strategist at MF Global. "There was a lot of institutional money sitting on the sidelines during the worst of the crisis that now is looking for (higher) yields."
Another report showed U.S. business activity contracted in May at a sharper rate than expected. For more see [ID:nN29401427].
While the dollar has typically attracted safe-haven flows on bad economic news, some analysts said deficit worries have weakened that relationship.
Boris Schlossberg, director of FX research at GFT Forex, said that as global risk appetite increases, the dollar may start selling off on lackluster domestic economic reports.
Bond yields retreated on Friday, though they are still up sharply since mid-March, when the Federal Reserve announced plans to buy longer-dated Treasuries to keep rates low.
With long-term yields higher and the dollar under pressure, analysts at Barclays Capital say global investors "are demanding a greater risk premium for holding U.S. assets." (Additional reporting by Vivianne Rodrigues; Editing by James Dalgleish)