LONDON: The euro inched up against the dollar on Friday as investors unwound bearish bets on the single currency to book profits ahead of the weekend, but with the euro zone debt crisis escalating, appetite to sell on upticks was high.
With Italian and Spanish bond yields close to unsustainable levels, pressure was mounting on the European Central Bank to step up its bond-buying programme in the face of rapidly falling demand from other investors.
Until a solution emerges that makes the ECB the lender of last resort, the euro is unlikely to sustain any gains.
Selling pressure on the euro has intensified this week on signs that the contagion was spreading to core euro zone countries such as France.
With German bond yields no longer moving lower as peripheral yields rise, analysts said this suggested that portfolio adjustments were not just moving from peripheral debt to core Bunds, but that investors were abandoning the euro zone altogether.
The euro rose 0.3 percent to $1.3502, not far from its five-week low of $1.3421 struck on Thursday. It is still down roughly 2 percent for the week.
Support for the euro lies at around $1.3405, the 76.4 percent retracement of the October rally.
"With so much up in the air there's nothing else to focus on apart from the immediate, which is that the euro zone looks to be heading into the precipice. Ahead of the weekend I don't think anyone is ready to counter that view," Jane Foley, senior currency strategist at Rabobank.
Traders say that since the bulk of investors are already running bearish positions on the euro in the past few months there was very little scope for the currency to fall more despite what some politicians have described as the worst crisis in the region since World War II.
Most investors were still looking to sell into every rally.
"The market has an appetite to take on new shorts because without the ECB there doesn't seem to be any other buyer in the European sovereign debt market," Foley said.
While highlighting the risk that the short squeeze could push euro/dollar higher in the near term Commerzbank strategists said the prevailing trend was for a lower euro.
"Courageous market participants can sell the euro around 1.3550-60, we would start shortening EUR-USD at 1.3650," the bank said in a note.
DOLLAR FUNDING STRAINS
With investors shunning euro zone assets, funding strains were increasing for euro zone financial institutions, boding ill for the euro and other riskier assets while offering support for the perceived safety of the US dollar.
The premium for swapping euros into dollars rose on Thursday, with the three-month cross-currency basis swap around 6 basis points wider at 136 basis points, the most since the 2008 financial crisis.
Analysts said that the rising cost of bank funding was pushing institutions into shorter duration funding and could spread into spot currency markets, weighing on the euro.
"I think we'll break $1.30 but I think it's going to be in a fairly orderly fashion," said Jesper Bargmann, Asia head of G11 spot FX for RBS in Singapore, adding that there were likely to be some spikes and bouts of short-covering in between.
The dollar dipped to a two and a half week low against the yen of 76.68 yen. Wariness about the possibility that Japan may intervene further in the wake of its massive yen-selling intervention on Oct. 31, has lent support to the dollar recently.
A trader at a Japanese bank said dollar offers from Japanese exporters were likely to put downward pressure on the dollar towards the month-end.
The Australian dollar, which tends to come under pressure in times of market stress, dipped to a five-week low of $0.9966 and was last flat on the day at $0.9992.
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