* Sterling follows euro lower vs dollar, initial Italy optimism fades * Market sees risk of dovish BoE inflation report this week * Euro/sterling hovers near 8 1/2-mth low, risks more losses on EZ debt issue By Naomi Tajitsu LONDON, Nov 14 (Reuters) - Sterling fell against the dollar on Monday, tracking losses in the euro against the safe-haven U.S. currency as investors reined in initial optimism over a new Italian government. Selling by macro funds and Eastern European names pushed the pound lower, according to traders, as investors booked profits on the pound's broad gains so far this month. Some market participants also saw some downside risks to sterling this week, with the Bank of England widely expected to revise down its forecasts for UK growth when it releases its inflation report on Wednesday. "The inflation report in isolation should be negative for sterling, but the overall picture is that the focus will remain on the euro zone, and that should be positive (for the pound)," said John Hydeskov, currency strategist at Danske. Many in the market have sold the euro in favour of the pound this month, pushing it to an 8 1/2-month high last week, on the view that UK assets are safer than some euro zone ones in light of the deepening debt crisis in the region. On Sunday, Italy's president appointed former European Commissioner Mario Monti to head a new government charged with implementing urgent reforms to end a crisis that has endangered the whole euro zone. The euro traded 0.2 percent higher at 85.70 pence, having hit a session high of 86.03 pence, but it remains near a level of 84.86 hit last week which was its lowest since March. Hydeskov at Danske said he expected the euro to edge down towards 83 pence in the near term, as most traders remain unconvinced whether technocratic administrations in Italy and Greece can win back investors' confidence in their deteriorating debt situations. Against the dollar, the pound traded 0.8 percent lower at $1.5940, having fallen as low as $1.5924. Technical analysts at Barclays Capital said the pound remained at risk of a fall towards $1.5900 and $1.5860 this week so long as it stayed below technical resistance at $1.6170, its 200-day average. In addition to the inflation report, figures this week on UK employment and retail sales may put the pound under some selling pressure if they show the economic recovery is continuing to struggle. A sluggish economy prompted the Bank of England to add to its asset-buying programme last month. Such a move is often considered to be currency negative as it involves flooding the market with currency. But sterling has held up despite the renewed quantitative easing, and analysts believe a lack of real economic progress in Italy and Greece would keep sterling supported against the euro. HIGHER REAL YIELDS? Some market participants believe sterling has more to gain across the board in the next few months, given an expected rise in real yields -- reflecting the impact of inflation -- in the coming months. Peter Kinsella, currency strategist at Commerzbank, said that at around -2.7 percent, real yields in the UK have the lowest among G10 currencies as relatively high inflation in the UK has eaten into gilt returns. But as the impact of a rise in VAT passes and the rise in energy prices peters out next year, many in the market expect inflation pressures to subside significantly from above 5 percent at the moment. Along with revising its growth forecast lower, the BoE is widely expected to reiterate the risk of a sharp fall in inflation, which would raise returns on UK versus U.S. and euro zone assets. "If the MPC comes out and says it expect the inflation rate to move much lower in the coming months and quarters it could actually be positive for sterling in the longer term," said Commerzbank's Kinsella. "Real yields should rise to a flat level or above (if inflation falls sharply). Compared with significant negative real yields in the U.S. and increasingly negative ones in the core euro zone, real yields for GBP are getting a bit better." (Reporting by Naomi Tajitsu; editing by Patrick Graham)

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