* Euro pulls back from two-month high against dollar
* Market looking to start of U.S. quarterly earnings
* Yen slips, then recovers after Japan election results (Updates prices)
By Steven C. Johnson
NEW YORK, July 12 (Reuters) - The euro retreated on Monday from a two-month peak against the dollar as investors said the currency was overbought ahead of European bank stress test results due next week.
The yen struggled overnight after Japan's ruling party suffered a stinging defeat in a weekend parliamentary election but recouped its losses during North American trade.
Some market participants said the euro took a hit after a German magazine reported over the weekend that the bank stress tests would, under certain conditions, include loan markdowns on German sovereign debt. That clashed with reports last week that the tests would exempt German haircuts. For details, see[ID:nLDE66A061]
But it was largely technical factors that held the euro in check, particularly the currency's failure to rise above a downtrend line drawn through its December high. The euro was last trading at $1.2594 EUR=, down 0.4 percent, and resistance was seen just above $1.27, around a two-month high touched on Friday.
Traders reported Asian demand around the day's lows at $1.2550 with automatic stop-loss orders lurking just below. Stronger bids are seen around an approach of $1.25.
"We're still generally in correction mode, but we remain pretty negative on the euro in the second half of the year," said Shaun Osborne, strategist at TD Securities in Toronto.
"There's still some upside potential, but after retesting and failing to break the trendline, we've seen some negative price action, and I think you'll see the euro settle into a $1.23-$1.27 range for a while longer."
Debt woes in Greece and fears about bank exposure to troubled euro zone countries in June drove the euro to a multiyear trough below $1.19 before staging a corrective rally. The euro is still off 12 percent against the dollar in 2010.
Details of the stress tests on 91 European banks are due on July 23 as the European Union seeks to restore confidence in the sector. [ID:nLDE66B06L]
If the tests are deemed insufficiently severe, markets are likely to punish the euro and fear the worst about Europe's banks, Osborne said. "The tests must be realistic," he said.
Data showed speculative bets against the euro were trimmed last week, and some analysts say that may leave room for investors to start rebuilding euro shorts. [ID:nN09105731]
YEN RECOVERS, STERLING WOBBLES
Against the yen, the dollar was unchanged at 88.59 yen JPY=, having climbed as high as around 89.15 yen after Prime Minister Naoto Kan's Democratic Party of Japan (DPJ), lost its upper house majority in an election on Sunday, putting at risk efforts to deal with the country's debt.
Tokyo traders said the election outcome initially sparked unwinding in long yen positions, which rose sharply last week.
Sterling fell 0.2 percent to $1.5030 GBP=D4 after ratings agency Standard & Poor's affirmed the UK's "AAA" long-term rating but maintained a negative outlook. [ID:nN12221887]
Markets were looking ahead to second-quarter earnings results from U.S. firms, with Alcoa Inc. reporting on Monday. A recent string of weak U.S. economic data has raised speculation the recovery may be losing momentum, hurting the dollar.
Those fears also helped the yen recover its post-election losses, as the currency tends to rise when investors grow averse to risk and unwind trades financed with borrowed yen.
But Boris Schlossberg, a director for currency research at GFT Forex, said that if U.S. company earnings this week suggest interest rates are likely to rebound off their recent lows, the dollar will move higher against the yen irrespective of political uncertainty surrounding Kan and the DPJ. (Additional reporting by Vivianne Rodrigues; Editing by Leslie Adler)