* Dollar soft as Fed tightening expectations subside for now * Traders see rebalancing dollar sales after big Q1 gains * Investors still see potential rise in inflation worries * Graphic: World FX rates tmsnrt.rs/2RBWI5E TOKYO, April 7 (Reuters) - The dollar softened to a two-week low against a basket of currencies on Wednesday after U.S. bond yields declined as traders rolled back aggressive expectations that the Federal Reserve will tighten its policy earlier than pledged. The dollar index hit a two-week low of 92.246, slipping further from a five-month high of 93.439 set on March 31, and last stood at 92.343. “Following the dollar’s strong gains last quarter, some investors appeared to have over-allocation in dollar assets and they probably need to sell dollars for rebalancing,” said Kazushige Kaida, head of FX Sales at State Street Bank’s Tokyo branch. The previous quarter saw the dollar’s strongest rally in years on rising expectations that accelerating U.S. economic growth and inflation could force the Fed to abandon its pledge to keep interest rates near zero until 2024. The dollar index rose 3.6% in the quarter, its biggest quarterly rise in three years. Against the yen, the U.S. currency rose 7.2%, the largest since the last quarter of 2016. As some bullish bets on the dollar were unwound this week, the euro rallied to a two-week high of $1.18785 and last stood at $1.1867. Similarly, the common currency jumped almost a pence against the British pound overnight to trade at 85.90 pence, its biggest gain since Dec. 10, in a reversal from the pound’s steady gains during the last quarter. The dollar was on the defensive at 109.77 yen, extending its retreat from a one-year high of 110.97 touched a week ago. The dollar is nearing a critical juncture to maintain its long-term uptrend, said Osamu Takashima, chief currency strategist at Citigroup Global Markets Japan, noting a break below a key support level from its 21-day moving average, at 109.40 now, could herald a bearish turn. Another key technical indicator, the 14-day relative strength index (RSI), is already flashing a warning sign, falling below its previous bottom of 66 to 62, he said. Traders were recalibrating their expectations on the Fed for now after U.S. interest rates futures earlier this week had priced in a 0.25 percentage point rate hike by the end of 2022. The five-year U.S. Treasury yields dropped sharply to 0.874% after hitting a 14-month high of 0.988% on Monday. Yet many investors think the jury is still out on whether the Fed can stick to its dovish stance. “Vaccines are now helping to boost U.S. economic activities, while we also have largesse from the government spending and easy money from the central bank... So while the Fed says it is not worried about inflation, markets still are. The risk for interest rates is still on the upside,” State Street’s Kaida. Elsewhere, the Australian dollar held firm near a two-week high against the dollar at $0.7652 while the British pound slipped to $1.3824 from Tuesday’s two-week high of $1.3910. Bitcoin was flat at $57,872.