The euro touched two-month lows versus the dollar on Tuesday, hovering near its weakest level since January as euro zone sovereign downgrades threatened after EU leaders failed to agree strong steps to tackle the debt crisis.
The euro recovered, helped by short covering, after it failed to break below a reported barrier at $1.3150. But traders said there remained a clear bias among investors to sell the single currency on any bounce.
The euro was up 0.1 percent at $1.3196, having hit a low of $1.3160, leaving the October low of $1.3145 within range.
Moody's said on Monday it intends to review the ratings of all 27 European Union states in the first quarter of 2012, while credit agency peer Fitch said pressure on their ratings had risen after last week's EU summit yielded no "comprehensive" crisis solution.
"The last blow for the euro was the announcement from the ratings agencies last night," said Niels Christensen, currency strategist at Nordea in Copenhagen.
"The technical configuration is turning against the euro. If it breaks below the early October lows then very quickly $1.30 would be in the frame, plus we have thin markets. It all adds up to a clear bias to the downside for euro/dollar."
The announcements from Moody's and Fitch followed a warning from Standard & Poor's of a possible downgrade of 15 euro zone countries after the summit ended.
Net euro short positions totaled 95,814 contracts in the week through December 6, according to Commodity Futures Trading Commission data, and market participants said shorts likely increased in the wake of the summit.
Although the data suggested a strongly negative sentiment towards the euro, the single currency could gain short-term support as investors take profits on or cover those positions.
"There are short positions built up in the euro now so a rise on short-covering is possible, but for the short term, for the coming week or so, a fall in the euro seems more likely unless there are any fresh developments about support for the euro zone," said Masafumi Yamamoto, chief FX strategist for Japan at Barclays Bank.
MacNeil Curry, technical strategist at Bank of America/Merrill Lynch, dropped his bullish euro/dollar call and adopted a neutral view following the euro's drop below $1.3212.
"With the break of support, the next level of note is 1.3146. Through here would turn us negative, opening significant downside potential, targeting 1.2510," he said.
Pressure on the euro and heightened risk aversion increased the dollar's safe-haven appeal, lifting the dollar index to 79.651, its highest this month, before it dipped back to 79.374.
The dollar index was above its weekly Ichimoku cloud top for the first time since September 2010.
Later on Tuesday, the Federal Reserve will hold its final policy meeting of the year but it is not expected to take any action other than some finishing touches on its communication strategy. Many analysts expect the Fed to wait until a two-day meeting on Jan 24-25 before launching any new initiatives.
Ahead of the Fed, investors are waiting for a closely watched survey of German analyst and investor sentiment, as well as US retail sales data.
The risk-sensitive Australian dollar was up 0.35 percent at $1.0107, approaching its 55-day moving average at $1.0120, having earlier shed more than 1 cent to a two-week low of $1.0030.
Support now lies at its 21-day moving average of $1.0047 and then at parity, followed by $0.9942, which would represent a 61.8 percent retracement of its November-December climb.
Market liquidity was thin ahead of year-end holidays, which could hurt demand in bond sales by Italy and Spain on Wednesday and Thursday. Weak results would add to pressure on the euro.