The euro crawled up from eight-month lows on Tuesday as a report that Europe is considering beefing up its bailout fund prompted short-covering, and it could extend its rebound in the very near term given traders' overwhelmingly short positions in the currency.
Asian currencies also rebounded after massive selling in the past two weeks, helping to ease worries about growing contagion from the euro zone's debt crisis to the world economy and supporting the euro and other risk currencies.
But the euro remained vulnerable to persistent doubts over policymakers' ability to craft a plan quickly to deal with the crisis. Growing expectations that the European Central Bank will likely cut interest rates as early as next month are also expected to undermine the currency in the longer term.
"Markets are getting more confident around some action plan in Europe, which is positive, but on the other side, markets are also looking for more policy easing from the ECB, which is negative," said Greg Gibbs, currency strategist at RBS in Sydney.
"The combination of both will leave the euro caught in the middle somewhere."
The euro traded at $1.3532, flat from late US levels but holding above an eight-month low of $1.3360 hit on Monday. Oscillators such as the relative strength index show the currency is near oversold territory.
Data from the US financial watchdog also showed that speculators' net euro short positions at the Chicago Mercantile Exchange last week were at the highest level since June last year.
On the other hand, resistance looms at $1.3580, a 38.2 percent retracement of its Sept. 15-26 decline.
The currency stood at 103.29 , having bounced from a fresh decade low at 101.90 yen hit on Monday, weathering some month-end selling from Japanese exporters.
The latest catalyst for the euro's rebound was a CNBC report that European officials are considering setting up a special purpose vehicle to buy distressed debt from banks to magnify the firepower of the region's rescue fund.
ECB Executive Board member Lorenzo Bini Smaghi said in New York on Monday that the existing €440bn in the bailout fund, known as the European Financial Stability Facility (ESFS), could be used as collateral to borrow from the European Central Bank, making more money available for crisis fighting.
Some market players say such a scheme could help the euro zone fend off further deterioration in the euro zone's debt woes.
"CDS spreads for countries such as France and Germany are rising while those for Southern countries have fallen, with the exception of Greece. This may be telling us that markets may be thinking that the worst part of crisis could be over for most (troubled) countries except for Greece," said a trader at a Japanese bank.
Still, traders remained nervous about whether the 17 country currency bloc could form a united front to fix its debt problems given its history of internal disagreements. This week alone, the euro zone faces plenty of hurdles, including votes this week in Finland and Germany on the earlier EFSF structure. The Greek government votes Tuesday on new austerity measures needed to secure aid.
The Japanese bank trader also said that many investors are not active in the euro because of uncertainty over the debt crisis, making the euro's moves choppy.
"Apart from European repatriation and sovereign players' orders, trade is becoming limited as investors want to avoid risk in light of uncertainty over policy," he added.
The euro could be hurt by growing expectations of a rate cut by the ECB as some ECB officials said on Monday that cuts could not be ruled out, lifting European shares.
"Rate cuts will be negative for the euro in terms of yield attraction. If a rate cut helps to shrink credit spreads, that could be considered as a positive for the euro but I think over time it will have an adverse effect," said Koji Fukaya, chief strategist at Credit Suisse in Tokyo.
Risk currencies also rebounded a tad after a wild selloff in the past two weeks, with the Aussie bouncing back to $0.9880, from a 10-month low of $0.9622. Most Asian currencies stabilised, with the Korean won traded at 1,179.0 won per US dollar , off a one-year low around 1,196.0.
The dollar index edged down 0.4 percent to 77.86, after hitting an eight-month peak of 78.863.
The dollar remained stuck against the yen at 76.36, though traders reported growing talk Japan could intervene this week ahead of the end of their financial half-year. The yen has gained nearly 6 percent so far this year.
Early on Tuesday, Japan's government said it wants to bring forward steps to ease the pain some companies feel from a stronger yen and enact the measures before it completes an extra budget to fund reconstruction spending.For all the latest business news from the UAE and Gulf countries, follow us on Twitter and Linkedin, like us on Facebook and subscribe to our YouTube page, which is updated daily.
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