The dollar's rally stalled on Monday as investors bought euros to square up positions ahead of a key policy meeting by the U.S. central bank later this week.
Dollar and Euro
"The market is holding its breath ahead of the Fed tomorrow, so we are not surprised to see the dollar a little lower here after a strong performance last week," said Matthew Strauss, senior currency strategist, at RBC Capital Markets in Toronto.
"For the first time in a number of FOMC (Federal Reserve Open Market Committee) meetings, there is significant uncertainty about the decision and the statement," he added.
U.S. short-term interest rates futures are showing the market perceives an 82 percent chance that the Federal Reserve will cut interest rates by a quarter percentage point to 2 percent on Wednesday .
Meanwhile, with global inflation rising, some analysts are speculating that the Fed could indicate it is approaching the end of its cycle of drastic interest rate cuts.
The dollar slipped against a basket of currencies. The euro edged up slightly against the dollar, snapping a three-day decline. But it was still below last week's record high.
Comments from European Central Bank officials repeating their warnings about persistent inflation have lent mild euro support for most of the session.
ECB President Jean-Claude Trichet and Governing Council member Yves Mersch both said risks to price stability remained on the upside, with Trichet adding that there were no grounds for complacency.
Their comments suggested the ECB is not ready to start cutting interest rates from 4 percent soon, even with regional data pointing to an inflation slowdown in four German states for April.
A surprise jump in a gauge of German consumer sentiment also helped the euro, as it indicated that the euro zone's biggest economy may be in better shape than indicated by last week's weak Ifo business confidence survey.
"We had a relatively strong reading in German consumer confidence and that helped ease concerns about a faltering German economy following last week's disappointing Ifo number," said Omer Esiner, a market analyst at Ruesch International in Washington.
"I think there were some hawkish comments by Trichet and also by Mersch and that sort of underpinned the euro a little bit," he added.
Meanwhile, rising commodity prices -- with oil hitting a new record high -- kept the dollar on the back foot.
Against the yen, the dollar hit a two-month high of 104.82 yen, but came down slightly down on the day.
Sentiment on the dollar improved last week amid stronger-than-expected U.S. corporate earnings and a growing view that the worst of the credit crisis has passed.
But some analysts are not convinced that the dollar's rally may be sustained given the continued fragility of the financial system and the still considerable stress in credit markets.
"Barring a more hawkish bias in the FOMC statement, which seems less likely to us, additional dollar gains in the near-term, particularly ahead of the Fed announcement, may prove difficult," said HSBC Bank USA in a research note.
The Fed has slashed borrowing costs by 3 percentage points since September in response to the credit crisis that erupted last year, but some speculated that climbing fuel and food prices could put the brakes on any more big cuts.