The euro rose against the dollar on Wednesday, reversing a drop to a near three-week low earlier in the global session, as optimism that Italy can resolve its political gridlock offset weak German data.
The euro had fallen after a survey by Germany's Ifo think-tank showed business sentiment dropped for a second month in April, fueling concerns about the health of the euro zone's largest economy.
The euro was already vulnerable after German PMI data on Tuesday showed business activity dropping sharply in April.
"The release of softer Ifo data from Germany drove a brief decline in the euro, albeit one that was quickly retraced," said Eric Theoret, forex strategist at Scotiabank in Toronto.
Early on the euro dropped to $1.2954, its lowest since April 5, before paring losses to last trade up 0.2 percent at $1.3019. An Asian central bank and a supra-national investor were cited as buyers.
"With regards to the outlook for the ECB, focus has turned to next Thursday's meeting, with rising expectations for an easing in monetary policy," Theoret said.
(Read More: ECB Rate Cut Could Bring Big 'Disappointment')
The European Central Bank currently has rates at a record-low 0.75 percent.
Recent comments by ECB policymakers have stressed falling inflation and poor euro zone growth prospects, suggesting policymakers are leaning towards a further cut at their next meeting on May 2.
With interest rates in the United States and Japan at or near zero, an ECB rate cut would diminish the euro's yield advantage. The ECB has refrained from pumping massive amounts of money into the euro zone through asset purchases, unlike the Federal Reserve or the Bank of Japan's actions on their economies.
Traders said the euro drew some support from reports that Italian President Giorgio Napolitano had called on Enrico Letta, deputy head of the center-left Democratic Party, to form a new coalition government.
The formation of a government in the euro zone's third-largest economy after months of uncertainty would offer relief to investors looking to buy assets in the region.
"But the risk-reward in the euro is to sell it into any rise to $1.3100/50," said Mankash Jain, head of FX and Investment Management at hedge fund Solo Capital. "The data from Germany has been weak, the Ifo was weak and if the ECB were to cut rates next week, the euro would fall."
Weak Data Hits Dollar
The dollar fell against the yen after data showed orders for long-lasting U.S. manufactured goods recorded their biggest drop in seven months in March and a gauge of planned business spending rose modestly, adding to signs of a slowdown in factory activity.
While the yen remains weighed by the Bank of Japan's ambitious bond-buying program announced this month, concerns about global growth have lifted the currency recently.
The dollar hit a four-year high of 99.94 yen on April 11 after the Bank of Japan unveiled a sweeping monetary stimulus program which entails buying $1.4 trillion of bonds in less than two years.
The dollar last traded at 99.45 yen, flat on the day.
Many traders are braced for a test of the 100 yen mark in coming days, although offers were reported around 99.80-85 yen that could limit the dollar's gains in the short term.
Despite expectations of a rate cut by the ECB, the euro rose to a five-week high against the Swiss franc on renewed speculation that the Swiss National Bank could raise the floor imposed on the euro/Swiss franc pair to 1.25 francs from 1.20.
The euro rose 0.3 percent to 1.2324 francs, its highest since mid-March. It went past a reported options barrier at 1.2300 francs, with traders citing talk of a Swiss bank selling the franc against the dollar.