The EU launched legal action against Hungary in January over three pieces of legislation which Brussels says conflicts with EU law, and hurts the independence of the central bank, the data protection authority and the judiciary.

EU diplomats expect the Commission to move forward with a second letter later on Wednesday with stronger wording and more points reflecting concern on the retirement age of judges and on the data protection authority.

An announcement is expected after 1100 GMT.

In February, Hungary said it could push the dispute on judges' retirement ages all the way to the European Court of Justice.

A letter would be one step closer to a possible EU court case, although many steps would remain in a lengthy procedure.

The legal dispute has so far blocked Hungary's efforts to start formal talks with the EU and the International Monetary Fund (IMF) over a financing backstop which the country needs to cut its borrowing costs and retain access to markets.

A spokesman for Hungarian Prime Minister Viktor Orban also held out the prospect of further questions from the EU.

"It's conceivable that the Commission will not be satisfied with the government's answers on some issues, we hope this will not be the case," spokesman Peter Szijjarto told HirTV late on Tuesday.

As for the planned IMF/EU standby loan, an EU diplomat close to the issue said on Tuesday he was not aware of any formal preconditions but the issue of central bank independence was important regarding when talks could start.

"If the Commission doesn't say strongly negative things about the central bank issue tomorrow, if they say they are making progress with the Hungarians, then there should be no obstacle for a deal. If they come out with harsh wording on the central bank, then that could change the picture."

Government spokesman Szijjarto said the legal dispute should not be linked to the planned aid talks as those were separate issues.

Hungary's forint, which plunged to a record low versus the euro in the first week of January, has firmed sharply in the past few weeks on hopes for a quick agreement with the IMF, but the timetable for talks has been pushed back gradually.

Initially markets expected a deal by April, now analysts project the agreement could be sealed by the end of June.

POLICY ANCHOR NEEDED

With the forint firmer than 300 to the euro and yields on government bonds back at around 8 percent, down from peaks of 11 percent in early January, the Hungarian government is no longer under immediate pressure to sign a quick deal with lenders.

At 0801 GMT, the forint traded at 294.29 versus the euro.

"My nagging suspicion all along has been that the Orban administration would only do an IMF deal if forced by the market to do so," said Timothy Ash at RBS. "I guess these suspicions are coming home to roost now."

"Arguably the forint at current levels is not at a level that the government thinks that it has to cut a deal with the EC/IMF at all/any cost - it still thinks that it has wiggle room to negotiate a little more with the EC, prior to getting agreement to begin talks on a formal IMF program."

This strategy may not be viable if investor sentiment sours as Hungary's economy, with its high debt and foreign currency debt exposure, is vulnerable to external shocks.

The government also needs the IMF deal to rebuild investor confidence in its economic policies, after two years of controversial measures which included Europe's biggest bank tax and a renationalization of private pension fund assets.

If the start of formal talks on aid is delayed further, markets' patience could easily run out.

"If there is a negative assessment (by the Commission) and the government keeps on saying it will not change tack and we cannot even guess when the aid talks could restart, that could trigger a negative reaction, all the more so as the global backdrop is now given for such a move," said Zsolt Kondrat at MKB.

(Reporting by Krisztina Than/Robin Emmott in Brussels; Editing by Toby Chopra)

• A Permanent Economic Emergency