NEW YORK: The euro edged higher against the dollar and yen in volatile trade on Tuesday as risk aversion abated somewhat, but gains were capped by record high Spanish bond yields on the country's bank bailout and fears over Sunday's Greek elections.
Reports of official preparations for a Greek exit from the euro zone, uncertainty about the logistics of Spain's bank bailout and the rise in Spanish and Italian government bond yields had investors selling the single currency on bouts of strength.
Rising skepticism over a 100 billion euro zone bailout for Spain's banks pushed Spanish government bond yields to their highest since the euro was launched in 1999. Investors are concerned over how difficult it may be for Madrid to access debt markets in the longer term. Current holders of Spanish debt are worried about falling to the back of the line for repayment.
"Foreign exchange traders have become fixed income traders," said Dean Popplewell, chief currency strategist at OANDA in Toronto, alluding to the fact traders are watching euro zone sovereign bond yields as a guide to foreign exchange rates.
"The market is worried about a snowball effect and the bigger dynamics of Spain's economy," he said. "Spain, as a country, may eventually request a bailout."
The euro last traded at $1.2482, up 0.1 percent on the day, but above a session low of $1.2441. Against the yen the euro rose 0.1 percent to 99.12 yen.
"Selling into strength should continue to be the market's mentality and nobody will be comfortable holding risk headed into this upcoming weekend," said Popplewell.
Concerns that the Greek election on June 17 would bring to power parties opposed to its current bailout plan and force a disorderly exit from the euro zone were rekindled by a report that EU officials were considering ways to manage the fallout.
A win for parties opposing the austerity terms of Greece's bailout would leave the country on the brink of bankruptcy and an eventual chaotic exit from the euro.
On the other hand, a win for the parties supporting reforms and austerity could provide some relief and see the euro bounce.
The result of Greece's election looked too close to call between parties supporting and opposing the international bailout and harsh austerity measures accompanying it.
As a worst-case scenario should Athens decide to leave the euro, European officials have discussed limiting the size of withdrawals from ATM machines, imposing border checks and introducing euro zone capital controls.
The options market reflected the skittishness among traders with 1-week euro/dollar implied volatility spiking to a six-month high at 14.9 percent as quoted by ICAP, up from 10.8 percent last Friday.
Some of the outstanding issues of Spain's bank bailout are whether the sovereign debt holders will be subordinated by the bank aid; which vehicle will fund the package; and what the interest rates and terms will be.
Underscoring the fear that Spain's bailout would not solve the euro zone's sovereign-debt problem, Austria's finance minister said Italy may need a financial rescue because of its high borrowing costs, drawing a furious rebuke on Tuesday from the Italian prime minister.
The yen fell after the International Monetary Fund said it was moderately overvalued and there was a chance of further yen appreciation due to Europe's debt crisis.
The dollar rose 0.03 percent to 79.42 yen.
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