Euro continued to drop against the dollar for the second day on Wednesday, as investors become wary of the impact of higher euro-zone interest rates on peripheral euro nations struggling with sovereign debt crisis.

The euro fell to $1.3865 in the European session, extending its retreat from a 4-month high of $1.4036 hit on Monday. Euro traded above $1.40 amid speculations that the European Central Bank (ECB) would raise the interest rate as early as next month.

Traders said stop-loss orders were triggered on the break of $1.3940, $1.3925 and $1.3885.

The problem with the interest rate driven trade and Trichet's hawkish comments is that you have to see the other issues behind it, said Reuters quoting John McCarthy, director of foreign exchange at ING Capital Markets in New York. Higher rates will be devastating on the peripheral countries.

We're seeing continued euro/dollar selling from the real money community. It feels like the market wants to target 1.3880-1.3850, a London-based trader said.

Further, investors remain cautious ahead of the European Union’s summit on Friday, where leaders are expected to come out with a comprehensive plan to tackle the debt crisis.

However, investors remain concerned that no concrete solutions would come out of the EU meeting.

Eurozone’s debt woes resurfaced on Monday after Moody’s downgraded Greece’s sovereign debt rating by three notches from Ba1 to B1 with a negative outlook.

Morgan Stanley on Monday said that it expects the euro to face some near-term headwinds from sovereign debt crisis in Europe. However, it predicted the euro to gain strongly once the monetary tightening starts, WSJ reported.