Ulrich Leuchtmann, head of FX research at Commerzbank in London, said the ZEW data would throw into question the European Central Bank's grim economic forecasts for the region and growing expectations of an interest rate cut early next year. The Bundesbank has also slashed its growth forecast for Germany in 2013 and warned that Germany could tip into recession.
On Monday, the euro had hit a two-week low against the dollar on rate-cut expectations, a gloomy economic outlook and political turmoil in Italy after Prime Minister Mario Monti said over the weekend that he would resign early. But it recouped lost ground after Monti said there was no danger of a vacuum before the elections.
'Fiscal Cliff' and Fed in Focus
Bets that the White House and Congress will reach a deficit reduction deal by the end of the year caused stocks to rally Tuesday, but weighed on the dollar. An agreement is needed to avoid massive tax increases and spending cuts beginning early next year that economists say could send the United States back into recession,
The dollar's status as a safe-haven currency means it would likely fare well if the United States fails to avoid the crisis.
U.S. House of Representatives Speaker John Boehner, the top Republican, offered no concrete signs of progress Tuesday on the "fiscal cliff" talks with the White House, but said he remained hopeful that both sides would reach an agreement by the end-of-year deadline.
Investors were also reluctant to buy the dollar with the start of the Fed's policy meeting. The Fed is expected to replace its expiring "Operation Twist" program with another Treasury bond-buying plan when it issues its policy statement Wednesday.
"We anticipate the Fed will announce Treasury purchases, and as that depresses yields it will have a negative impact on the dollar, and that supports the euro," said Jane Foley, senior currency strategist at Rabobank in London.
Many economists believe the Fed will announce monthly bond purchases of $45 billion, although some think it could be more.
The expectations of more Fed easing pushed the Canadian dollar higher, with the U.S. dollar falling to a two-month low, while the New Zealand dollar hit a nine-month high. The New Zealand dollar also rose to a 2-1/2-year high against the yen.
Against the yen, the dollar was last up 0.25 percent at 82.54 yen, not far from an eight-month peak touched last month on growing expectations an election Sunday could result in pressure for more stimulus from the Bank of Japan.
Dollar/yen price movement remains constricted given that the tight range from Nov. 22 has narrowed further over the past four sessions, according Eric Theoret, currency strategist at Scotiabank in Toronto.
"Prior levels of support for dollar/yen that had been just below 81.80 have risen above 82, while resistance has remained solid above 82.80," he said.
"Any potential for yen strength in reaction to a dollar-negative Fed decision would be mitigated by near term expectations of BoJ policy," he added.