The euro scaled 14-month peaks against the dollar on Tuesday, gaining in three of the last four sessions, lifted by an improving euro zone outlook and expectations the Federal Reserve will keep its ultra-easy monetary policy for some time.
German economic data and signs European banks were on the mend boosted hopes that the worst of the euro zone crisis was over, driving the euro up 2 percent against the dollar so far this year.
The euro had earlier rallied to just below $1.35, a key resistance and psychologically important level. Analysts expect the level to eventually break, which would open the door to a rise toward $1.3835.
The focus has also been on the Fed's monetary policy meeting, which started the first of its two-day gathering on Tuesday. Investors expect a continuation of quantitative easing beyond this year, a negative for the dollar as it expands the currency's supply.
"The expectation is that the Fed will continue to pump money into the financial system and while that's good news for the stock market, that's bad news for the dollar," said Chris Gaffney, co-chief investment officer at Everbank Wealth Management, in n St. Louis, Missouri.
"In contrast, we have the European Central Bank moving to take away some of those stimulus and effectively, it is on a tightening path. That has been the difference."
The euro rose as high as $1.3497, the highest since Dec. 2, 2011. It last traded up 0.2 percent at $1.3485. The slight increase in a German consumer confidence indicator to 5.8 heading into February from 5.7 the previous month helped the euro as well, as the data continued the trend of improving sentiment surveys in the euro zone's largest economy.
Gaffney added that while euro zone fundamentals remained weak overall, they are being overshadowed by U.S. fiscal problems.
Analysts at ActionForex.com said the euro's intraday bias is back on the upside and sustained trading above $1.3486 will extend the whole rally to key resistance at $1.3790. They added that as long as the $1.3264 support holds, the near-term outlook should stay bullish.
Action Economics said buying by UK and German names helped drive the euro's latest move higher, adding that proprietary names and an Asian central bank are looking to sell near $1.3500. Defense of the $1.3500 option barrier may also limit the momentum.
Investors Unwind Long Bunds Trade
Douglas Borthwick, managing director at Chapdelaine Foreign Exchange in New York said investors are beginning to feel more comfortable about long positions on the euro.
"German yields rising should be seen as a good thing in Europe. It represents an unwinding of the long Germany, short everything else in Europe trade," Borthwick said. He added that the euro will continue to rise as long as the two-year euro currency basis swaps, a measure of funding conditions in the euro zone, continue to tighten.
The euro briefly rose and hit a session high after data showed U.S. consumer confidence dropped in January to its lowest level in more than a year.
Aside from the Fed, investors are also looking out for the first estimate of U.S. fourth-quarter GDP due on Wednesday, two days before the January jobs report. Weak readings on the U.S. economy could add to expectations of continued monetary easing by the Fed and weigh on the dollar.
The dollar dropped against the yen, slipping further away from a 2-1/2-year high hit a day earlier, but analysts said yen weakness will resume as investors look to buy the dollar back at lower levels.
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Traders cited demand for six-month yen puts, or bets the currency would fall, from a U.S. investor who bet dollar/yen would rise to 97 yen in six months through option strikes.
The dollar slipped 0.2 percent to 90.64 yen, down from Monday's high of 91.25 yen, its strongest level since June 2010. Traders reported options barriers at 91.50 and 92 yen.
Selling the yen has been mostly a one-way trade since mid-November, based on expectations that Japanese Prime Minister Shinzo Abe would push the Bank of Japan into more forceful monetary easing to beat deflation.
Present BOJ Governor Masaaki Shirakawa, whose term ends in April, is expected to be replaced with a more dovish governor, who could then bring forward any easing, giving further impetus to yen bears.