The euro rose 0.2 percent on the day to $1.3719, reversing a fall to $1.3593 in early trade. Traders cited Mideast demand, which prompted a short squeeze — when a rise forces players to back off short-term bets a currency will fall.
A 1.5 percent rise in European shares also provided a boost to the euro as did a cut back in bets in favour of the U.S. currency ahead of a policy announcement by the Federal Reserve on Wednesday.
The U.S. central bank is expected to announce more monetary stimulus to kickstart the U.S. economic recovery, and may leave the door open to additional quantitative easing.
“The market came in after the downgrade anticipating more euro weakness. It’s been caught wrong footed and that’s why we’ve had an amplified move higher,” said Daragh Maher, senior currency strategist at Credit Agricole CIB
He added: “There’s a reluctance to be aggressively long on the dollar going into the Fed. Even if they don’t announce QE3 they could suggest they may in the future.”
The euro recovered losses suffered after Standard & Poor’s cut its sovereign rating for Italy by one notch to A, taking it three notches below Moody’s current rating.
Traders said the single currency also got a lift on a report citing Japanese Prime Minister Yoshihiko Noda reaffirming Tokyo would buy bonds issued by the euro zone’s rescue fund, as it has already done.
Despite the claw back in the single currency, big gains were unlikely given that investors continue to price in the possibility of a Greek default as Athens waits to see if it can clinch a deal for more bailout funds.
“Any news that brings Greece closer to bankruptcy or a debt restructuring will put the euro under more downside pressure,” said Niels Christensen, currency strategist at Nordea in Copenhagen.
“I wouldn’t be surprised to see a test of $1.35 in the next week,” he said.
Just a week ago, the euro fell as low as $1.3495, its weakest since February. A break below that could open the way for a test of $1.3410, the 50 percent retracement of its rise from June last year to May this year.
The single currency’s intraday recovery quelled euro/dollar implied volatility. One-month implied vol traded around 16.1 percent, retreating from 16.25 earlier in the day when spot euro/dollar plumbed the session low.
One-week vol pulled back to 16.5 from 17.0, but a further slide was unlikely given the risk that volatility will stay high before the Fed announcement. One-month risk reversals show a slightly strengthening bias towards bets to sell the euro.
The single currency traded at 104.50 yen , after falling to 104.00 yen, a whisker away from a 10-year low of 103.90 yen hit last week.
The dollar slipped 0.2 percent versus a currency basket , and was down 0.1 percent at 76.50 yen .
The Australian dollar rose 0.7 percent to US$1.0240, benefiting from a short squeeze in higher-risk currencies. The New Zealand dollar rose 0.1 percent.
Investors trimmed long positions in the dollar before a policy announcement on Wednesday by the Fed, which is expected to start shifting its asset holdings into longer maturities to help the sputtering U.S. economy.
Analysts see a risk that the dollar could be hurt in the near term if the Fed adopts bolder easing steps than markets are expecting, such as another round of asset purchases, known as quantitative easing.
Such a move would flood the market with dollars and drive the value of the U.S. currency lower, analysts say.
Instead, the Fed may to try to push low long-term interest rates even lower this week by tilting towards longer duration bonds in its portfolio, a move known as Operation Twist.
This, however, may not be enough to boost significant demand for riskier assets, and may keep selling pressure on the euro and higher-yielding currencies, but any indication that the U.S. central bank will implement more QE if needed is likely to trigger dollar selling.
A total of 23 market announcements were recorded during Abu Dhabi Finance Week