FOREX-Dollar rises ahead of Fed meeting

* FOMC begins two-day policy meeting later on Tuesday

* Risk sentiment wanes as China stocks continue to droop

* After Fed, U.S. GDP in focus on Thursday

By Lisa Twaronite

TOKYO, July 28 (Reuters) - The dollar firmed on Tuesday as cautious investors covered short positions ahead of the start of a two-day U.S. Federal Reserve meeting and as a continued slump in Chinese equity markets sapped appetite for riskier assets.

The safe-haven yen was below the previous session's highs hit after Shanghai stocks tumbled 8.5 percent, their biggest drop in eight years, which helped pull down European and U.S. share markets.

Losses continued into Tuesday's trading, even as Beijing pledged more support.

The dollar rose about 0.3 percent on the day to 123.570 yen after falling as low as 123.010 yen on Monday, while the euro was up about 0.2 percent at 136.92 yen, after rising as high as 137.10 in the previous session.

"The Chinese market dropped by about 8 percent yesterday, but the dollar/yen dropped by just around 1 percent, which means many people in the FX market think the Fed is likely to hike as early as September so they don't want to sell a lot of dollars," said Masashi Murata, currency strategist for Brown Brothers Harriman in Tokyo.

"The market is risk-off, and yet the yen is not so strong," he said.

Some investors believe the Fed's rate-setting Open Market Committee is laying the groundwork for hiking rates this autumn, which has underpinned the dollar in recent weeks.

"We think FOMC will surprise on the hawkish side, provided a highly conditional lean to a 2015 lift-off is viewed as hawkish," Steven Englander, global head of G10 FX strategy at CitiFX in New York, wrote in a note to clients.

"Continued Chinese equity market weakness that spills over into U.S. asset markets in a major way would deter them," he said, although he added that current U.S. share levels were not low enough to trouble the U.S. central bank.

"The international dimension for the Fed is whether they think the relevant central banks can deal with the shocks their economies and assets markets are facing. Contagion would have to be much sharper to really register as a proximate risk sufficient to affect U.S. policy," Englander said.

The dollar index, which tracks the U.S. unit against a basket of six major rivals, edged up 0.1 percent to 96.593 , after falling as low as 96.288 on Monday, its lowest since July 14.

The euro inched down about 0.1 percent to $1.10820 after scaling a nearly two-week peak of $1.11295 on Monday as risk-averse investors pared their euro-short positions.

After this week's Fed meeting, the next main event for the dollar will be second-quarter U.S. gross domestic product, the first estimate of which will be published on Thursday.

The economy is seen returning to growth, expanding by 2.7 percent, after a contraction in a weather-hit first three months.

U.S. data on Monday showed non-defense capital goods orders excluding aircraft rose in June, but shipments of core capital goods used to calculate equipment spending in the government's gross domestic product measurement slipped 0.1 percent. (Editing by Richard Pullin & Kim Coghill)