Risk appetite in currency markets diminished in early London trading on Wednesday, with the dollar partially erasing its overnight losses, after China's foreign ministry said the United States told China on July 21 to close its consulate in Houston.
The dollar rose and the euro fell, reversing the "risk-on" trend of the previous 24 hours, after China's foreign ministry said at around 0730 GMT that it had received the abrupt notification -- an escalation of recent U.S.-China tensions.
Beijing said it strongly condemns the move and threatened retaliation.
Markets had been firmly pro-risk overnight, boosted by hopes for an economic recovery, with the euro hitting an 18-month high of $1.1547 after European leaders agreed on a massive stimulus plan for the euro zone.
But these moves reversed after China's statement, with the euro retreating to $1.1521 by 0804 GMT.
The dollar index, which had hit its lowest since early March on Tuesday evening on hopes for an economic recovery, erased some losses as risk appetite worsened on Wednesday. It was up 0.2% at 95.292, still trading close to four-month lows.
China's offshore yuan weakened past 7 per dollar on the news and was last at 7.0028.
"That headline triggered some profit taking, quite an aggressive one in USDCNY, USDCNH," said Christy Tan, head of markets strategy for Asia at National Australia Bank in Singapore.
"It's a timing issue. All this is coming as tensions between the U.S. and China are escalating. This added fuel to fire," she said.
Westpac FX analyst Sean Callow said the headlines from Houston had caught traders off-guard, sparking fears that perhaps this latest dispute could be the one to halt the U.S.-China trade deal, something he rates as unlikely.
"I'd be a bit surprised if there's much follow through ... it's probably just a wobble," he said.
The Australian dollar erased the day's gains. Having hit a new high of $0.7168 versus the U.S. dollar -- its strongest since April 2019 -- at 0711 GMT, it then retreated to $0.7129, flat on the day.
A flare-up of cases and the reintroduction of lockdown measures in Australia's second-largest state had little impact on the currency, even after reports that the latest virus outbreak will cut the country's third-quarter GDP growth by 0.75 percentage points.
The New Zealand dollar also erased its gains from earlier in the session and was flat on the day at $0.6641.
The dollar was weakened earlier in the session by concerns about a possible delay to U.S. fiscal stimulus, as the Republicans and Democrats struggle to reach a consensus on the next round of economic stimulus measures.
"Somehow everything looks a little better for the euro than for the dollar. One-nil for it in the fight against the virus and the recession," Antje Praefcke, Commerzbank FX and EM strategist, wrote in a note to clients.
MUFG strategist Derek Halpenny noted the dollar had weakened sharply in 2010-12, which was also a period when real U.S. treasury yields were falling sharply.
"We are of a long way off another form of hawkish guidance the like of May 2013, so new lows in 10-year real yields look likely which will only reinforce the medium-term negative outlook for the dollar," he said.
The United States reported more than 1,000 deaths from COVID-19 on Tuesday, according to a Reuters tally, the first time since June 10 the nation has surpassed that milestone.
California was close to passing New York in total infections.
U.S. President Donald Trump shifted his rhetoric and tone on Wednesday, saying that the coronavirus pandemic will get worse before it gets better.