The euro rallied against most major currencies on Wednesday, recovering from a two-year low against the dollar after a European Central Bank policymaker said he could see grounds for giving the euro zone bailout fund a banking license.

The comments from Ewald Nowotny prompted a flurry of short-covering as the euro jumped higher, with some investors who had bet against the single currency being squeezed out of those positions.

But many analysts said the move was overdone and predicted further weakness ahead.

A banking license would allow the European Stability Mechanism to leverage its balance sheet and give the fund far greater ability to act in the euro zone credit markets, amplifying its power as backstop for European Union member sovereign bonds, said Boris Schlossberg, managing director of FX strategy at BK Asset Management. The euro/dollar is grossly oversold and due for some upside relief.

The euro hit a session high of $1.2169 and was last up 0.6 percent at $1.2131.

A banking license would give the European Stability Mechanism more firepower to fight the debt crisis but analysts said the market may have put too much emphasis on the comments, given ECB opposition to date, and investors would likely sell into the euro's rally.

The market is desperate and jumping on anything that even looks remotely positive, said Geoff Kendrick, currency strategist at Nomura.

It touched a two-year low on Tuesday against the dollar when some EU officials said Greece was unlikely to be able to pay what it owes and further debt restructuring is likely to be necessary.

The outlook remains deeply negative given spiraling Spanish borrowing costs that have fueled concerns the country will need a full sovereign bailout.

A break below support at the psychologically important level of $1.20 would open up a test of the 2010 low.

A worse-than-expected German business climate index ate into some of the single currency's gains, adding to concerns activity in the euro zone's largest economy is slowing down.

Adding to concerns, the European Central Bank's latest lending survey found banks made it harder for firms to borrow in the second quarter and expected to see a slump in demand as the euro zone debt crisis deepened.

MORE PAIN FOR SPAIN

Spain paid the second-highest yield on short-term debt since the birth of the euro at an auction of three- and six-month bills on Tuesday, indicating difficulties in future debt sales.

Yields on Spanish debt have jumped since last week when the region of Valencia said it would need financial help from Madrid, with investors concerned other indebted regions will also seek aid.

Delivering yet more bad news for Europe, Moody's changed the outlook on its provisional top-notch rating for the European Financial Stability Facility to negative.

The action was expected given its move earlier in the week to put a negative outlook on Germany, the Netherlands and Luxembourg.

Despite the bleak outlook, the euro's respite against the dollar also pushed it higher against other currencies.

Against the yen, it rose to 95.18 yen, having carved out a new 12-year low of around 94.11 yen earlier in the week. Traders in Tokyo cited talk of a euro/yen option barrier at 94.00 and stop-loss offers under the level. The euro last traded at 94.93 yen, up 0.7 percent.

The Australian dollar was about an Australian cent from a recent record high against the euro, trading at A$1.1790.

The Australian currency gained against the U.S. dollar after Nowotny's comments fanned demand for perceived riskier currencies, climbing 0.6 percent to US$1.0281.