The dollar hit a six-week high versus a currency basket on Monday after U.S. leaders failed to agree deficit-cutting measures, darkening the fiscal outlook and prompting a shift from riskier currencies into the safety of the U.S. currency.
The dollar index .DXY rose to 78.477, its highest since October 10 as debt problems deteriorated on both sides of the Atlantic due to ongoing worries that wrangling between European leaders will protract the bloc's debt crisis.
Investors sought growing yield premiums to hold Italian and Spanish bonds versus benchmark German debt, pushing the euro to the day's low versus the dollar.
An overwhelming Spanish vote in favor of a new government failed to instill optimism about Madrid's ability to deal with its economic problems.
The failure of Washington's supercommittee triggered selling in risky assets, with European shares falling 2 percent while currencies considered to be higher risk, including the euro and the Australian dollar also took a hit.
For the moment, Washington is still expected to push ahead with $1.2 trillion in automatic spending reductions despite its inability to find appropriate budget savings, keeping at bay the risk of an immediate credit rating cut.
So long as Washington avoids a lower rating -- which was slashed to AA+ a few months ago -- analysts believe the dollar may continue to benefit from safe-haven flows.
If the United States fails to reach agreement and we assume the spending cuts will still be delivered, that would be acceptable to the ratings agencies, said Adam Cole, global head of currency strategy at RBC.
But he added: If the automatic spending cuts are called into question, that would be problematic for the U.S. credit rating and by extension for the dollar.
The euro fell 0.4 percent on the day to a session trough of $1.3435, before pulling back to around $1.3460 as traders suspected Asian sovereign demand in the $1.3430 region.
The euro also suffered as the yield spread between Spanish and German 10-year government bonds yawned 10 basis points to 453 basis points, while the Italian/German spread also widened.
The dollar was flat at 76.88 yen, recouping earlier losses.
Many have been surprised by the euro's resilience to the surge in Italian and Spanish bonds yields which make it ever more costly for their governments to manage their debt.
It's been difficult to push it lower despite the problems in the euro zone, said Arne Lohmann Rasmussen, chief analyst at Danske in Copenhagen. From a speculative point of view, the market is already very short on euro/dollar.
The latest IMM data show that speculators ramped up their bets to sell the euro last week, leaving limited room to put on many more new positions to sell.
Analysts at Lloyds argued that in addition to speculators, longer-term participants have been selling the euro in past weeks, and that selling from the latter may pick up even if the IMM data shows limited scope for speculative positioning.
Any future euro weakness looks more likely to come from selling from commercial or longer term real money accounts, which have been reluctant EUR sellers for most of this year, they wrote in a note.
Analysts say the European Central Bank's unwillingness to commit to large-scale bond purchases and Europe's deteriorating economic backdrop mean financial markets will remain hostage to stresses in the region, which may hurt the euro.
The European Commission will propose on Wednesday much tighter control of euro zone countries' budgets and closer economic monitoring which, if proven to work, could lead in a few years to some form of joint euro bonds, a senior euro zone official said.
While such a move could help bolster confidence in the longer term, few think such drastic measures could be taken any time soon, given Germany's staunch opposition to the idea.