NEW YORK (Reuters) - The euro fell against the dollar on Tuesday after two days of gains as investors pared back expectations that an informal meeting of European leaders this week would yield much progress in tackling the region's debt crisis.
However, given the market's stretched bearish positioning and oversold signals on the technical charts, the euro could see a short-term squeeze higher ahead of the European summit.
The yen, meanwhile, tumbled after Fitch downgraded Japan's ratings and although the currency posted the biggest loss versus the dollar, investors remained focused on the euro.
While there have been hopes in some quarters that Wednesday's summit may lead to agreement on measures to boost euro zone growth, investors were not confident of a breakthrough given apparent differences in opinion between Germany and France.
French President Francois Hollande is expected to push for a joint euro zone bond, a measure backed by Italy, Spain and the European Commission.
However Germany, Europe's largest economy and paymaster, has so far opposed the move and continues to champion austerity measures. A German official said on Tuesday euro bonds did not offer a solution to the region's problems.
"The string of summit meetings that have been called to address the euro crisis thus far have more often than not failed to live up to market hopes for quick and decisive action and this one will be no exception," said Shaun Osborne, chief currency strategist at TD Securities in Toronto.
In midday New York trading, the euro was down 0.6 percent against the dollar at $1.2742, though it held above last week's four-month low of $1.2642.
However, with speculators' short euro positions at a record high, traders were wary of any development that could trigger a squeeze higher. <IMM/FX>
"I doubt any news out of the meeting tomorrow will be able to create a positive environment, but people booked some profit at the end of last week and may be waiting for better levels to sell the euro," said Niels Christensen, FX strategist at Nordea.
Concerns also remained that Greece could leave the euro after elections next month, and about Spain's troubled banking sector. The Institute of International Finance said Spanish banks could need another 76 billion euros to cover loan losses.
Analysts said risk aversion remains a key driver in the current uncertain environment and with a shrinking universe of safe-haven currencies the U.S. dollar should retain a better bid tone overall.
The dollar index rose 0.3 percent to 81.341 .DXY, rising after three days of losses.
Flows data from U.S. custody bank BNY Mellon showed that the U.S. dollar was the most bought currency on Tuesday, with net inflows accelerating in recent sessions at a pace that was twice as strong as seen last year.
Among emerging markets, BNY Mellon data indicated that most high-yielding currencies remained under pressure. The bank said it saw steady outflows from the South African rand, Mexican peso, Russian ruble, and Hungarian forint in recent sessions.
The greenback also held gains after data showed U.S. existing home sales rose 3.4 percent to their highest annual rate in nearly two years, although the report didn't really impress some analysts.
"I think we're still a ways away from looking at an encouraging picture of the U.S. economy, though when it comes to housing, every little bit helps," said Camilla Sutton, chief currency strategist at Scotia Capital in Toronto.
"We have been seeing prices fall so this pick-up is a good thing. And it's a substantial pick-up of the sort we have not seen in quite some time."
The yen, meanwhile, lost ground against the dollar after Fitch rating agency cut Japan's long-term ratings to A+, citing Japan's high and rising public debt ratios and a "leisurely" fiscal consolidation plan.
The dollar was up 0.8 percent against the yen at 79.97 yen. Important support for the yen is at its 200-day moving average around 78.53 yen.
Also on Tuesday, the OECD said the United States and Japan were leading a fragile economic recovery among developed countries but that this could be blown off course if the euro zone fails to contain its debt crisis.
Additional reporting by Steven C. Johnson; Editing by James Dalgleish