The euro retreated from a six-week high versus the dollar on Tuesday after comments from the German Chancellor tempered market optimism that policymakers will take major steps toward solving the euro zone debt crisis at a summit on Wednesday.
Angela Merkel said Germany is opposed to a phrase in the EU summit draft that calls for support for continued ECB non-standard measures, referring to the central bank's secondary market purchases of bonds.
The ECB has been buying government debt to check rising borrowing costs for some euro zone peripheral countries, notably Italy and Spain.
The euro was last trading at $1.3900, dropping sharply after Merkel's comments. It had earlier hit $1.3960, its highest level since September 8 on optimism European leaders would deliver a convincing plan to contain the debt crisis.
Traders cited decent offers around $1.3980-90, close to resistance at $1.3988, the 200-week moving average. Further resistance was seen around $1.4040, a 50 percent retracement of the euro's May to October decline, and traders also cited talk of an options barrier at $1.40 being defended.
The euro has rallied steadily since European leaders neared a deal over the weekend on bank recapitalization. Euro zone officials also said France and Germany were close to agreement on how to leverage the euro zone's rescue fund to stop bond market contagion.
However, analysts said investors would need to see a positive outcome from the region's second summit in four days for the euro to break above $1.40, while its current strength left it vulnerable to a sell-off in the event of disappointment.
It's now pretty clear we are going to get a certain amount of clarity on bank recapitalization as well as on Greece and the EFSF (rescue fund). I am not sure there's much scope for surprises from the summit, said George Saravelos, currency strategist at Deutsche Bank.
With many market players still short of the euro, he said any moves higher were accentuated as investors covered those positions, particularly amid broad dollar weakness.
Uncertainty remained about whether any plan would prevent contagion to larger countries, and over the extent of the losses private bondholders would take on Greek debt.
Analysts said the euro could top $1.40 after the summit as investors closed their short euro positions, but it could drop sharply again if short-covering later dwindled and euro zone debt worries increased.
The fact that these short positions are still there suggests there is certainly a risk of the euro going above $1.40, but it is questionable whether it would sustain those gains, said Jane Foley, Rabobank senior currency strategist.
It would be foolhardy to dismiss the possibility of an attempt at the downside.
Commodity Futures Trading Commission data last week showed speculators still had a large net short euro position.
Analysts were also concerned the euro zone's debt problems could worsen if growth slows sharply, particularly after weak purchasing managers' surveys on Monday highlighted concerns the region may be slipping into recession.
The yen hovered just shy of a record high against the dollar, leaving investors nervous about possible intervention by the Japanese authorities to stem the currency's rise.
Japanese Finance Minister Jun Azumi again warned markets against pushing up the yen too far, saying he was ready to take firm steps if its gains became excessive.
The dollar was steady at 76.12 yen, near a record low of 75.78 yen hit late last week on the EBS trading platform.
The dollar index, which measures the greenback's value against a basket of currencies, slumped to a six-week low of 75.94, highlighting its underperformance.
The chance of more monetary stimulus from the U.S. Federal Reserve has weighed on the dollar recently as some policymakers have stressed the need to boost a weak economy.