Euro Falls for 3rd Day on Nagging Funding Worries

The euro also tracked the rise in credit default swaps and the widening of yield spreads between the safe-haven German bunds and peripheral fixed income debt, suggesting growing nervousness about liquidity in the financial system and sustainability of the region's debt.

This is all emblematic of the fact that the market remains very nervous about the state of credit in the euro zone, said Boris Schlossberg, director of FX research at GFT Forex in Jersey City.

Despite the fact that we had a decent Spanish bond auction, there is just basic skepticism not only about the sovereign debt market but also the health of the overall banking system, particularly in Spain.

Spain's Treasury issued 2.5 billion euros in two- and 10-year bonds, at the top end of the targeted amount. Yields on the key 10-year bond were higher, however, reflecting fears that Spain may miss budget deficit targets and about its banking sector.

The euro dropped 0.2 percent to $1.3087 after hitting a session low of $1.3068, reversing gains that took the single currency to $1.3164 following the Spanish auction.

Traders said they were inclined to sell into any euro rallies, with the rise in Spanish and Italian yields undermining any optimism from the auction. Market talk of a French downgrade also undermined sentiment towards the common currency.

The euro also modestly sold off after a report showed that U.S. initial jobless claims were weaker than expected, which slightly dampened risk appetite.

The euro held above strong chart support at $1.30. But an escalation of concerns about Spain's high level of debt, at a time when the economy is faltering, would put the euro back under pressure, potentially taking it towards the 2012 low of $1.2624.

The market has come to realize that positive bond auctions are not Spain's salvation, said Neil Mellor, currency strategist at Bank of New York Mellon, adding it was only a matter of time before the euro broke below $1.30.

There are too many negative elements in the euro zone. If $1.30 breaks, we have only got minor levels of support until the January lows. We cannot preclude a sudden move lower.

Many in the market said the euro would head lower in the medium term given the risks that budget and debt problems in Spain will worsen and uncertainty over the outcome of the French presidential election, which polls suggest will result in a leadership change.

Traders cited talk of hedge funds betting the euro will fall to $1.25 soon after the French poll concludes early next month.

The safe-haven Japanese yen, meanwhile, fell, as equities gained and after Bank of Japan Governor Masaaki Shirakawa stressed the central bank's commitment to powerful monetary easing.

The dollar rose 0.3 percent to 81.510 yen, triggering reported stop loss buy orders around 81.60 yen, with traders earlier citing flows related to the launch of a large investment trust by a Japanese investment bank.

The euro was up 0.1 percent at 106.79 yen, although resistance came in around its 50-day moving average at 107.44 yen.

The higher-yielding Australian dollar was steady against the U.S. dollar at US$1.0356.