* Drop in Treasury yields weighs on U.S. currency
* Investors ready for next week's Fed meeting
* 1-week implied vols for euro/dollar rise
* Longer-term bullish dollar bets building (Updates prices)
By Steven C. Johnson
NEW YORK, Oct 28 (Reuters) - The dollar fell on Thursday in tandem with Treasury yields as investors once again reassessed how much money the Federal Reserve was likely to commit to a second round of monetary stimulus when it meets next week.
The Fed has telegraphed its intent to boost growth by pumping more money into the economy through direct government bond purchases, and few if any investors doubt its resolve.
But investors are far from certain about how much money the Fed will spend. A New York Fed survey of dealers and investors included scenarios of up to $1 trillion, a figure larger than recent estimates. For details, see [ID:nLDE69R15M].
That snapped a two-day dollar rally, pushing the euro to the upper end of its recent broad range of about $1.3650-$1.40 and pushing U.S. bond yields down. The more money the U.S. central bank effectively prints, the more it will push down Treasury yields and reduce the appeal of dollar-based assets.
"The issue is whether the market believes the Fed will deliver significant quantitative easing over a definitive time line," said Peter Frank, a currency strategist at Societe Generale in London. "If they do, the dollar will weaken."
The euro rose 1.2 percent to $1.3925 EUR=, well off a $1.3759 session low, while the 10-year Treasury note US10YT=RR was up 16/32 in price to yield 2.66 percent, down from 2.72 percent late on Wednesday.
The dollar fell 0.8 percent to 81.02 yen JPY=, with small stop losses cited by traders in the 80.90 area with bids at 80.60 and 80.40. There are also solid barriers at 80.00.
Traders shrugged off a Bank of Japan decision to keep interest rates at zero while holding off on new policy initiatives. Analysts were still on alert for any dollar move below 80.41 yen, a 15-year low, for fear Japanese authorities could repeat last month's intervention to stem yen strength.
DOLLAR RALLY POSSIBLE
Wall Street analysts expect the Federal Reserve to buy $80 billion to $100 billion worth of assets per month under a new program widely expected to be unveiled on Wednesday, according to a Reuters poll. [FED/R]
Estimates for how much the Fed will eventually spend varied from $250 billion to $2 trillion. The market has been scaling back expectations as the event draws nearer.
Lingering uncertainty about how the Fed will announce more QE has increased market volatility, with one-week implied volatility for euro/dollar EURSWO= jumping to 15.3 percent on Thursday from 12.6 percent at the start of the week.
The dollar has shed 7 percent against major currencies since September .DXY, and some say it's due for a rally once the Fed reveals its easing plans.
"We remain inclined to trade the dollar tactically from the long side into the Fed meeting based on the idea that quantitative easing is over-priced," said Nomura currency strategist Jens Nordvig.
The euro's move through $1.3890 looks like a good opportunity to reestablish dollar longs, he said.
On Wednesday, a buyer of the Powershares Bullish Dollar Fund, an exchange traded fund, bought 55,400 March 23 calls at 61 cents each and 105,500 March 24 calls at 34 cents, said WhatsTrading.com options strategist Frederic Ruffy.
Both positions are opening buys and appear to reflect expectations for a dollar rally through March 2011.
Investors shook off news on Thursday of a breakdown in Portuguese budget talks, but some said worries about the banking sector and the debt problems in that country as well as Ireland and Greece could check euro gains.
The European Central Bank's quarterly Bank Lending Survey said more banks expect to tighten their credit standards for corporate loans in the fourth quarter.
The news could check ECB intentions to scale back emergency stimulus measures, said Tom Levinson, a forex strategist at ING. "This serves as a warning on what is going on in the real economy. It's less of a positive for euro but the real dominant force is still the U.S. story." (Additional reporting by Nick Olivari in New York, Doris Frankel in Chicago and Naomi Tajitsu in London;Editing by Chizu Nomiyama)