(Reuters) - The euro hit its highest in four years against the yen and rose versus the dollar on Wednesday after German Chancellor Angela Merkel's conservatives reached a deal with the Social Democrats on forming a grand coalition. Germany's two biggest political forces clinched a deal in the early hours and a new government should be formed before year-end, triggering a relief rally for the euro. "The grand coalition in Germany removes a big political uncertainty and will support the euro in the short term," said Arne Lohmann Rasmussen, head of currency research at Danske Bank in Copenhagen. However, he said euro gains against the dollar would be limited due to the prospect of further monetary easing from the European Central Bank and of the U.S. Federal Reserve scaling back stimulus next year. He recommended selling the euro if it strengthens to $1.37/$1.38. The euro was up 0.1 percent at $1.35765, having risen as high as $1.3600, its strongest since October 31. It rose as high as 138.16 yen, breaking above 138.00 yen for the first time since October 2009, with the potential to target the 2009 peak of 139.26 yen. It last traded at 137.95 yen. A survey showing German consumer sentiment at a six-year high also lifted the euro. It added to recent good news on Europe's largest economy after last week's unexpectedly robust Ifo business sentiment figures. A rise in short-term market rates also helped the single currency. Euro-priced bank-to-bank lending rates rose on Tuesday after the amount of extra money in the financial system fell to its lowest in more than two years. But traders said low volumes before Thursday's U.S. Thanksgiving holiday may exaggerate currency movements. Concerns remained about a weak euro zone economy and deflationary pressures which may prompt further action from the ECB. But traders said an expected small rise in euro zone inflation on Friday may help the euro. The dollar was up 0.4 percent against the yen at 101.66 yen. It hit a six-month high of 101.915 yen on Monday. However, the dollar dipped against a basket of currencies .DXY as U.S. Treasury yields fell on Tuesday. "The dollar is not really strengthening as yet because rates are still very low at the front end and the Fed continues to emphasize they are going to stay low," said Greg Gibbs, senior strategist at RBS in Singapore. Investors were also watching developments in the East China Sea, after two U.S. B-52 bombers on a training mission flew over disputed islands without informing Beijing. Some analysts said any escalation in tensions may lift the safe-haven yen, which has weakened in recent weeks.

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