The euro came within three cents of its record high against a broadly weak dollar on Monday and hit a lifetime peak versus the yen as euro zone interest rates are set to rise this week and maybe more next year. The single currency later came under pressure early in European trading as investors banked profits on its surge over the past week.
The European Central Bank is expected to raise rates to 3.5% this week. Some predict more tightening, although a recent surge in the euro has slightly dampened this view.
Euro zone rate expectations come against a backdrop of recent data pointing to a slowdown in the U.S. economy which has boosted expectations that the Federal Reserve might cut interest rates next year.
"We've had a strong move to the upside, so the market has calmed down somewhat. (The ECB) will continue to show they will tighten monetary conditions. They will hike in December and another time in the first quarter of 2007," said Benedikt Germanier, currency strategist at UBS in Zurich.
"We also expect the U.S. to slow down and the Fed to cut rates. Interest rate differentials will move in favour of the euro again."
The euro had risen to a 20-month high around $1.3370 earlier in Asia, before erasing gains to $1.3303 by 0900 GMT. It is within a few cents of its 2004 record peak of $1.3667.
The euro hit a record high above 154.10 yen before falling back to 153.72.
The dollar was up 0.1% at 115.57 after hitting a four-month low below 115 on Friday. Sterling was off last week's 14-year high against the dollar, trading at $1.9785.
Reflecting its broad weakness, the dollar slid to its lowest since March 2005 against a basket of currencies.
More Dollar Weakness
The U.S. currency slumped on Friday after the Institute for Supply Management's survey of U.S. national manufacturing in November showed a contraction in the factory sector for the first time in 3-1/2 years.
Currently, Eurodollar futures imply that traders expect the Fed to cut rates by up to three quarter-points by end-2007.
Most euro zone policymakers seem relaxed about the euro's surge since late November, apart from French politicians who are traditionally sensitive and vocal about exchange rates.
ECB President Jean-Claude Trichet is speaking later in Madrid.
"He is likely to express discomfort with the speed of recent euro gains. However, on levels, we believe he will be relatively more sanguine," JP Morgan said in a note to clients.
Japanese officials are also calm as a weaker yen helps exports. Japan's top financial diplomat Hiroshi Watanabe said he was not concerned about yen carry trades, adding that the market will decide on euro/yen exchange rates.
The yen hit 8-year lows against sterling and Swiss franc last week as investors, expecting only gradual rate rises in Japan, sold the yen to invest in higher yielding currencies.
Monday's data showed growth in Japanese firms' capital spending slowed in the July-September quarter, pointing to a downward revision in gross domestic product figures due later in the week.
The data also raised expectations the Bank of Japan may not be ready to raise interest rates at its policy meeting later this month.