* Euro under pressure from doubts over new Italian government
* Sterling struggles on central bank policy outlook (Adds details, quotes)
By Saikat Chatterjee
LONDON, May 21 (Reuters) - The dollar rallied to a five-month high on Monday as relief over the fading risks of an outbreak in China-U.S. trade war prompted investors to cut their short positions against the greenback.
Market players cut their dollar short positions for the fourth consecutive week, reducing the net outstanding short positions to its lowest since the start of the year, latest positioning data for the week ending May 15 showed.
"While the dollar is trading near the upper end of its recent trading ranges, the rally may have further room to run given the extent of short positions in the market," State Street Global Advisors head of macro strategy Timothy Graf said.
The overall size of short dollar positions has fallen to about $11 billion from a near seven-year high of nearly $28 billion in late April as hedge funds rushed to cover their short positions, sending the dollar surging.
Against a basket of its peers, the dollar rose 0.4 percent above 94 briefly for the first time since late December 2017. It was trading at 93.84 in late morning trade.
BMO Financial Group European head of FX strategy Stephen Gallo said in a note that long dollar positions are now joint third biggest, along with long Japanese yen, in G10 foreign exchange trading.
But that unwinding has not been uniform. JPMorgan strategists believe that while leveraged accounts have broadly unwound their short dollar bets, asset managers "have yet to meaningfully capitulate".
This week will bring about a further test for stubborn euro bulls with the release of May flash PMI data on Wednesday where markets will be waiting to see whether the first quarter slowdown in Europe has spilled over to the subsequent months.
The dollar rally over recent weeks has taken currency markets by surprise, rising 5.4 percent in just over a month. It was the currency's biggest gain since the last quarter of 2015, when the U.S. Federal Reserve was preparing markets for its first interest rate increase since the financial crisis of 2008.
An improving U.S. economy has led the Fed to raise interest rates faster than its central bank peers, who have been reluctant to end the policy support they have provided their economies. Currency markets have felt the impact, especially in euro and sterling.
"The dollar's advance is also a reflection of poor developments abroad," Brown Brothers Harriman global head of FX strategy Marc Chandler said.
Latest data out of Japan has highlighted that difference in economic strength, with the economy contracting in the first quarter of 2018. Meanwhile, Germany, the euro zone's biggest economy, has revised down its first-quarter growth.
In the euro's case, concern over fiscal laxity from a new coalition government in Italy has also weighed on investors' minds, at a time when expectations of an interest rate increase by the European Central Bank have been pushed back to mid-2019.
The euro fell half a percent on the day to $1.1717, its lowest since late November, as a sell-off in Italian bonds spread to other peripheral bond markets in Europe.
"The shift to looser fiscal policy and a less favourable stance towards the EU is reinforcing selling pressures on the euro in the near-term," MUFG strategists said.
Elsewhere, sterling slumped half a percent to $1.3412 , its lowest since Dec. 28, as markets prepared for data this week that may decide whether the Bank of England will raise interest rates at all this year.
Reporting by Saikat Chatterjee Additional reporting by Sujata Rao Editing by Louise Ireland