(Reuters) - The dollar held just below a four-year high against a basket of currencies on Friday, fuelled by the biggest yield advantage over the euro in nearly 15 years as the Federal Reserve contemplates hiking interest rates.

European equities shrugged off a sharp sell-off in Asian and U.S. markets overnight, clawing off one-month lows and led by euro zone banks, seen as the big winners of the European Central Bank's measures to prop up inflation and kick-start growth.

U.S. stock index futures pointed to a slightly firmer start on Wall Street after Thursday's sharp selloff triggered by Apple Inc APPL.O and the rallying dollar.

The dollar index .DXY, which tracks the greenback against a basket of major currencies, edged up to 85.278, not far from a four-year high of 85.485 hit on Thursday.

The dollar is on track for its 11th successive weekly rise, something it has not achieved in four decades.

"It's Friday and so we may see some consolidation, but in general the dollar has broken through a number of long-term levels, so there's scope for us to go further before we meet much resistance," said Neil Mellor, a strategist with Bank of New York Mellon in London.

"Against the euro we have a forecast in the low $1.20s for a year's time, but the way things are going we could get there fairly quickly."

The dollar has been driven higher by the divergent monetary policy outlooks between a rate-hike-contemplating Fed and an ECB and Bank of Japan that are mulling further stimulus.

The yield difference between 10-year U.S. Treasuries US10YT=RR and German Bunds DE10YT=RR reached its widest in nearly 15 years on Thursday, keeping pressure on the euro.

High bond yields tend to attract more fund inflows as bond investments account for a big chunk of international capital flows.

The euro was steady on the day at $1.2746 EUR=, after falling as low as $1.26955 on trading platform EBS on Thursday, its lowest since November 2012.

ECB HOPES

European stocks were initially caught in Wall Street and Asia's downdraft but quickly recovered as banking stocks extended gains.

The FTSEurofirst 300 index .FTEU3 of top European shares rose 0.3 percent at 1,376.61 points, retreating from its lowest level in almost a month hit the previous day.

Investors increasingly expect the region's banking stocks to rally in the next few months as the ECB steps up its efforts to support the currency bloc's anaemic growth.

Societe General equity analysts recommend buying European banks, as the central bank's asset quality review next month is set to bring more visibility on the sector.

"It's a theme that many clients want to play, but not necessarily directly with long positions on the cash market. There's been a big rise in the open interest in calls on banking stocks in the past few months," said Vincent Cassot, head of equity derivatives strategy at Societe Generale.

Brent crude nudged up to $97 a barrel but was still headed for its biggest monthly drop since April 2013 as rising supplies outweighed fears that U.S.-led strikes against Islamist militants in Syria and Iraq will disrupt oil production.

Slowing economic activity in Europe and Asia has dampened demand for oil, while supply is rising.

Spot gold XAU= added about 0.3 percent to $1,226.40 an ounce, after rebounding off Thursday's session low of $1,206.85 an ounce, which was its weakest level since Jan. 2. It looked set to snap a three-week losing streak, though dollar strength kept it in danger of breaking below $1,200 an ounce.

(Reuters) - Lending to euro zone households and companies contracted for the 28th month in a row in August, though at a slower pace, putting a keener spotlight on European Central Bank efforts to get credit flowing again.

Euro zone banks, particularly in the crisis-stricken countries, have tightened up on lending as they adapt to tougher capital requirements and undergo health checks, while companies are holding back on investments, unsure of the future.

The euro zone economy ground to a halt in the second quarter and with inflation in what ECB President Mario Draghi has called the "danger zone" below 1 percent for almost a year now, the ECB saw the need to add new stimulus steps in June and September.

The ECB has now started to offer banks four-year loans at ultra-cheap rates and plans to buy asset-backed securities and covered bonds from October to lighten the weight on banks' balance sheets and entice them to lend.

But economists in a Reuters poll are sceptical about whether the plan will work, saying bank lending to private euro zone businesses needed to grow at a 3-percent annual rate on a sustained basis to stir inflation.

August lending rates are nowhere near such levels.

In August, loans to the private sector continued to fall, down 1.5 percent from the same month a year earlier after a contraction of 1.6 percent in July, ECB data showed on Thursday. Private sector loans have not grown since April 2012.

"It remains questionable as to how much all the liquidity measures announced by the ECB will encourage banks to lift their lending," IHS Global Insight economist Howard Archer said.

"...it is also questionable how much businesses' demand for credit will pick up while the economic and political outlook looks so uncertain," he said.

WEAK LENDING IN IRELAND

Draghi told Lithuanian business daily Verslo Zinios in an interview published on Thursday a continued weakness in credit growth was likely to curb the euro zone recovery.

Euro zone companies rely mainly on bank funding rather than capital markets, which is why it is so crucial to fix lingering problems in the sector.

For that purpose, the ECB is putting the bloc's top banks through a thorough review of their balance sheets to weed out bad loans, update collateral valuations and adjust capital.

The picture varies across the euro zone. While lending to companies in Ireland fell at an annual rate of 11.8 percent in August - the fastest decline in three years - and 8.8 percent in Spain, it rose in Finland, Germany and France.

Euro zone M3 money supply - a more general measure of cash in the economy - grew at an annual pace of 2.0 percent in August, up from 1.8 percent in July.

The United States and its Arab allies bombed Islamic State targets inside Syria for the first time on Tuesday. The Sunni Muslim group has seized swathes of territory in civil war-torn Syria and Iraq, slaughtering prisoners and ordering Shi'ites and non-Muslims to convert or die.

Germany has ruled out taking part in air strikes, but did break a post-World War Two taboo on sending weapons to active conflict zones by agreeing to arm Kurdish fighters battling Islamic State fighters in northern Iraq.

A Philippine military intelligence source said he was aware of the threats to the German hostages from Abu Sayyaf, but doubted they would be carried out, predicting that the group would most likely negotiate a lower ransom.

"We take all threats seriously," he said. "But, based on our experience in dealing with this group, they are plain criminals who are only interested in getting money. They will eventually settle for a smaller 'board and lodging fee'."

According to media reports, the two Germans, a man and a woman, were seized at gunpoint from a yacht between Malaysian Borneo and the southern Philippines in April.

Abu Sayyaf has been blamed for beheadings, bombings and kidnappings for ransom. The group is also holding a Dutch, a Swiss, a Japanese and some Filipinos in the south of the mainly Roman Catholic state.

In 2001, Abu Sayyaf rebels in the southern island province of Basilan beheaded an American who had been taken captive from an island resort in Palawan province. Two other Americans were held for more than a year, and one was killed during a rescue operation. The other survived with minor wounds.

About 200 U.S. special forces troops have been deployed in the southern Philippines since 2002 to help train and advise local soldiers in fighting Islamist extremists.

(Reuters) - Algerian militants have beheaded French tourist Herve Gourdel, who was kidnapped by gunmen on Sunday in what the group said was a response to France's action against Islamic State militants in Iraq.

In a video released by his captors, Gourdel, a 55-year-old from Nice, is seen kneeling with his arms tied behind his back before four masked militants who read out a statement in Arabic criticising France's intervention.

They then pushed him on his side and held him down. The video does not show the beheading, but a militant later holds the head up to the camera.

"This is why the Caliphate Soldiers in Algeria have decided to punish France, by executing this man, and to defend our beloved Islamic State," one of the militants says in the statement he read out.

France's President Francois Hollande confirmed the death of Gourdel, and vowed that French military operations against Islamic State would continue.

"Our compatriot has been killed cruelly and in a cowardly way by a terrorist group. Herve Gourdel was assassinated because he was French," Hollande, visibly shaken by the events, said at the United Nations. "My determination is total, and this aggression only strengthens it. France will continue to fight terrorists everywhere. The operations against Islamic State will continue."

The Caliphate Soldiers, a splinter group linked to Islamic State militants in Iraq and Syria, had on Monday published a video claiming responsibility for the abduction and showed the man identifying himself as Gourdel.

The kidnapping had come after Islamic State spokesman Abu Muhammad al-Adnani urged the group's followers to attack citizens of the United States, France and other countries that joined the coalition to destroy the radical group.

Just before the militants gave their statement in the video, the Frenchman told his family that he loved them.

There was no immediate comment from Gourdel's relatives, but a friend, Eric Grinda, told France's i-Tele television: "They want to fan the flames of hatred and to make us want to respond. They only are able to do one thing, assassinate a man on his knees with his hands tied ... My sadness is immense."

France launched its first air strikes targeting Islamic State targets in Iraq on Friday. It has said all must be done to rid the region of the group.

France raised the threat level at 30 of its embassies across the Middle East and Africa on Monday.

DEEPENING ISLAMIST RIVALRIES

Western diplomats and intelligence sources say they believe there are fewer than 10 Western hostages still held by Islamic State. The group has recently beheaded two Americans, James Foley and Steven Sotloff, and one Briton, David Haines, and threatened to kill another Briton, Alan Henning.

The Frenchman's kidnapping was one of the first abductions of a foreigner by militants in Algeria since the North African country ended its decade-long war with Islamist fighters in the 1990s.

There have, however, been many attacks in the Maghreb region carried out by armed Islamists. In January 2013, al Qaeda-linked militants took more than 800 people hostage at a gas facility near In Amenas, Algeria. Algerian special forces raided the site, but 40 workers were killed, all but one of them foreigners, along with 29 militants.

Gourdel, a French nature guide and photographer, was taken hostage when militants stopped his vehicle in the remote mountains east of Algiers where he planned a hiking trip, according to Algeria's interior ministry.

Algerian troops had launched a search for Gourdel in the mountains in an area known as the "Triangle of Death" during the bloody days of Algeria's 1990s war with Islamists. Though attacks from Islamists are rarer, al Qaeda in the Islamic Maghreb and other groups are still active. The Caliphate Soldiers group earlier this month announced it had broken with al Qaeda in the Islamic Maghreb, known as AQIM, to back Islamic State, in another illustration of deepening rivalries between Islamic State and al Qaeda's core leadership. AQIM central region commander Khaled Abu Suleimane, who claimed leadership of the Caliphate Soldiers, is a hardliner who has consistently refused peace agreements with the government and traces his militant roots back to the 1990s war.

In that war, 200,000 were killed, as militants fought a bloody campaign - cutting throats, massacring villages and kidnapping civilians - to overthrow the government and install an Islamic state in Algeria.