EURO DOWNS AND SOLD AS WATER

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LONDON (Reuters) - The U.S. dollar treaded water on Thursday and the Japanese yen held on to its earlier gains after a Russian news report of mortar fire in eastern Ukraine jangled market nerves and boosted the appeal of safe haven bets.

Russia-backed rebels accused Ukrainian forces of shelling their territory in violation of agreements aimed at ending conflict in the contested Donbass area, the RIA news agency said, a report later denied by Ukraine.

While the greenback retreated from its Asian highs after the news broke, investors remained wary that Russia will invade the Ukraine again despite rising optimism at the start of this week that a diplomatic solution would be found to prevent conflict.

Against a basket of its rivals, the dollar steadied at 95.747 after rising above 96 in early Asian trading.

But in a sign that markets were not panicking yet, the rouble remained below a November 2020 high of 80 hit last month, while bond yields were only modestly higher.

"This strongly suggests that market participants remain optimistic overall that conflict will be avoided," MUFG strategists said in a client note.

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The geopolitical news dwarfed the Fed's minutes of its January meeting, where policymakers agreed that it was time to tighten monetary policy but also that decisions would depend on a meeting-by-meeting analysis of data, according to minutes of the most recent policy meeting.

Short-dated U.S. Treasury yields fell and the yield curve steepened after the minutes as traders reassessed the probability of a 50 bps hike at the Fed's March meeting. Money markets were pricing in a 72% likelihood of a 50 bps hike next month compared to 80% at the start of the week.

The euro rebounded from earlier lows after falling as much as 0.4% after the Ukraine news. But Ukraine's denial and the location of the reported attack within already contested territory calmed things and the euro last sat at $1.1382.

The yen and the Swiss franc clung on to earlier gains, up 0.2% and 0.1% respectively versus the greenback.