By Nick Olivari (FXstreet.com)

The dollar advanced against the euro and yen on Wednesday, to remain within striking distance of two-year highs, but pared some gains as investors grew cautious ahead of Thursday's U.S. trade report.

Economists expect the U.S. trade deficit to have widened to a record $61 billion in September, according to a Reuters poll. However, a larger-than-expected deficit poses the risk of halting the dollar's rally.

"If you get a number well above consensus, you could see a big sell-off in the dollar. There's no doubt that is the big risk," said Peter Frank, senior foreign exchange strategist with ABN-AMRO in Chicago.

Massive U.S. trade and budget deficits were the prime mover in the dollar's three-year decline from 2002 to the end of 2004. But speculative investors have recently built up sizable dollar positions based on expectations of higher U.S. interest rates relative to other major currencies.

A trade shortfall in the $63 billion to $65 billion range could trigger a partial unwinding of those positions.

The euro slipped 0.1 percent from late Tuesday to $1.1762, some 56 points from a two-year low around $1.1706 reached on Tuesday, according to Reuters data.

Against the yen, the dollar was up 0.3 percent at 117.56 yen after briefly dipping below 117.00 yen. The euro was up 0.1 percent against the yen at 138.32 yen.

The dollar has risen nearly 6 percent against the yen since August.

Traders have lightened up on yen negative positions recently, especially as data from the International Monetary Market showed speculative bets against the yen had been the largest in six-and-a-half years late last month.

"As these positions are unwound or at least trimmed to more manageable levels, the yen has a little bit more upside," said Thomas Molloy, a trader with Bank Hapoalim.

Late in the New York session, St. Louis Federal Reserve President William Poole the high and rising U.S. current account deficit, of which trade is the largest component, is not sustainable but its adjustment need not become disorderly provided the U.S. government and central bank pursue sound policies.

DEFICITS ON TAP

The euro has been under pressure since August, falling 5 percent against the broadly rallying dollar, which has benefited from expectations of higher U.S. interest rates relative to other major economies.

Widespread riots in France have added to the euro's woes in recent weeks.

"Markets hate uncertainty, so the euro will likely continue to struggle until the situation in and around Paris is resolved," said Chip Hanlon, President at Delta Global Advisors Inc. in Huntington Beach, California.

"Fortunately for investors, however, the common currency is quite oversold so a meaningful bounce could be witnessed soon," he said.

Pressure from euro zone finance ministers and business leaders for the European Central Bank not to raise rates, have also soured sentiment on the euro.

The U.S. Federal Reserve has quadrupled interest rates since beginning its credit tightening campaign last year, while the ECB has kept rates steady.

The market currently expects the ECB to raise interest rates as early as December, but the rhetoric among euro zone monetary policy-makers is mixed.

Traders will be keen to see how the euro performs if the September U.S. deficit is near the high end of forecasts.

"If EUR cannot respond to a wider deficit going into the U.S. long weekend, take as a given that EUR is a truly damaged currency," Richard Franulovich, senior currency strategist with Westpac Banking Corp, said in a research note.

The pound was little changed against the dollar, trading at $1.7423, after British Prime Minister Tony Blair suffered his first major parliamentary setback in eight years when the House of Commons rejected a proposal concerning terrorist suspects.

Major currencies generally move in narrow ranges ahead of Thursday's U.S. trade report, analysts said.

(Additional reporting by John Parry)