The euro rose against the dollar for a second session on Wednesday on increased risk tolerance after reports about a possible increase in the International Monetary Fund's lending capabilities and Fitch Ratings playing down an Italian default.
The single currency remained well off the 17-month low against the dollar touched last week, but many in the market believe the recent gains are tenuous.
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"We think markets are getting too bulled up on the IMF headlines today," said Win Thin, global head of emerging currency strategy at Brown Brothers Harriman in New York. "As the saying goes, 'Show me the money!' Until then, we remain skeptical that the IMF will be able to obtain the extra funding it desires."
Gains in the euro kicked off after an analyst at Fitch said it does not expect Italy to default, though a senior director said a two-notch downgrade to Italy's rating was an option.
Momentum picked up after the IMF proposed increasing its lending pool and said that it needs to raise $600 billion in new resources to lend to countries struggling with the fallout from the growing euro zone debt crisis.
In mid afternoon trading, the euro was 0.9 percent higher on the day at $1.2849, with the session peak at $1.2863, according to Reuters data. The euro, however, has not closed above its 20-day simple or exponential moving averages against the dollar since Oct. 31, according to Reuters data.
The euro zone common currency also earlier jumped against the Swiss franc, hitting a one week high but was last at 1.2075, down 0.1 percent on the day. The dollar was 1 percent lower against the Swiss franc at 0.9395 francs.
One-month implied volatility on euro/dollar, a gauge of a currency pair's movements in either direction, stayed subdued on Wednesday, trading in the 11.50-12.00 percent range, off the 15.00 percent level seen in December. That typically indicates diminishing anxiety about the debt crisis.
Risk reversals continued to show a bias for "puts" in euro/dollar or bets that the currency will depreciate, but they were off extreme levels, suggesting improving sentiment. On Wednesday, the one-month 25 delta risk reversal euro puts were at 1.05 vols, with some trades going through at 0.85 vol, traders said. That was a massive improvement euro puts of 4.35 vols hit in mid-November.
"Although very few people will argue that the European sovereign debt crisis will intensify in the coming months, euro/dollar is rallying on the hope of additional support from inside or outside of Europe," said Kathy Lien, director of FX research at GFT in Jersey City.
Still, analysts cautioned that the euro outlook was uncertain and gains were vulnerable, with talks resuming between Greece and its creditors on Wednesday to overcome an impasse and hammer out a bond swap deal to stave off a painful default.
Even if the IMF gets the extra financing, the additional funds may prove immaterial for problems in Greece, Ireland, and Portugal, Brown Brothers Harriman's Thin said.
The euro's gains have pushed the dollar index 0.8 percent lower at 80.573, although it was still within striking distance of a 16-month high hit on Friday.
The euro also drew support from solid demand at a German auction of two-year notes, while Portugal managed to sell short-dated paper despite being downgraded to "junk" status by S&P late last week.
Analysts say euro zone debt auctions, even for weaker countries, have been going well because of demand from banks, which many suspect have ample funds to invest in domestic debt after taking up a massive amount of three-year, low interest rate loans from the European Central Bank last month.
Despite its rally this week, however, investors say the euro will remain vulnerable to more evidence of fiscal and economic weakness in the region and see more selling if Greece is unable to reach a debt deal with its creditors.
Greece needs a deal with the private sector within days to avoid going bankrupt when 14.5 billion euros ($18.5 billion) of bond redemptions fall due in late March. The country's foreign lenders have warned no further aid will be released until the bond swap deal is completed. (Reporting By Nick Olivari and Gertrude Chavez-Dreyfuss; Editing by Padraic Cassidy)