The euro on Friday rose to its highest level in more than two months against the U.S. dollar in a rally that could be sustained in the short term, boosted by optimism about the crisis in the euro zone and all the cheap money to come from the European Central Bank next week.

Rising for a third straight day, the euro broke above the key 100-day moving average against the dollar for a second consecutive session. It also breached key resistance around $1.3435, the 50 percent retracement of the decline from the late October peak to the mid-January trough.

Meanwhile, the Japanese yen tumbled across the board, a downtrend that started with the Bank of Japan's recent monetary easing. Japan's trade deficit, widening interest-rate differentials with the United States favoring the dollar, and rising crude-oil prices also have hurt the yen's prospects. Against the euro, the yen fell to its lowest level in nearly four months.

I see this euro rally being sustained possibly to $1.36-$1.37 next week, said Douglas Borthwick, managing director at Faros Trading in Stamford, Conn. He cited the improvement in the euro swaps market, which has started to show an easing of funding strains in Europe from December's extreme levels.

The cross-currency basis swap, or the relative premium for swapping the euro London interbank offered rate for the dollar LIBOR, traded at -58.250 basis points on two-year contracts on Friday, off record peaks of -92.500 in mid-December.

Narrower spreads reflect reduced demand for U.S. dollars in the currency forward market and often supports the euro's spot value against the dollar.

Borthwick added that the ECB's three-year long-term refinancing operation next week could help the euro's cause. Estimates suggest that the LTRO would draw bids of anywhere between 500 billion euros and 1 trillion euros, setting risk appetite on fire.

A big take-up [of the LTRO] will support risk broadly, as easier bank- and sovereign-funding conditions reduce systemic risk globally, said Calvin Tse, currency strategist at Morgan Stanley in London.

Tse added that a significant amount of this cash may be used to fund sovereign carry trades, in which banks in the euro zone use their new three-year funding to buy debt of the region's sovereigns.

But that supply of low-interest cash could end soon. ECB Governing Council member Ewald Nowotny on Friday said he doesn't see any need for more LTRO after next week's operation.

In late-afternoon trading, the euro was last up 0.7 percent on the day at $1.34545, off an earlier peak of $1.34869, its highest point since early December.

Market players said the euro rally had good momentum after it broke through the 100-day moving average around $1.3306 on Thursday, and took out a reported option barrier at $1.34 in early European trade on Friday.

The next key level to watch out will be the $1.3623 area, which is the 61.8 percent retracement of the October to January drop.

The euro zone will also be the focus of this weekend's Group of 20 meeting in Mexico City. European Union leaders are likely to seek a significant increase in resources available to the International Monetary Fund to help the region fight the debt crisis.

Some market participants believe this euro uptrend still has momentum because of the tremendous amount of euro short positioning among speculators.

Ultimately, the fact that investors are still so short the euro is positive because, at some point, assuming the rally continues, they will need to unwind these positions which should further support the euro, said Nikolaos Panigirtzoglou, European head of global asset allocation and alternative investments at JPMorgan in London.

Latest data from the Commodity Futures Trading Commission showed net euro short positions were still at a hefty 142,159 contracts in the week to Feb. 21.

Yen Weakness

The yen was also one of the biggest movers of the day.

The dollar hit a fresh 7-1/2-month high of 81.062 yen on trading platform EBS and was last 80.990, up 1.4 percent on the day. The dollar has racked up gains of about 4.4 percent the last two weeks, the best two-week gain in nearly two years.

Greg Anderson, senior currency strategist at CitiFX in New York. said the he expects the yen's drop to reverse and expects a new floor to be set at 78.00 or 79.00.

Dollar/yen traditionally has a strong correlation with short-term Japanese-U.S. yield spreads. U.S. Treasury yields are not expected to rise much further due to the Federal Reserve's pledge to keep rates exceptionally low until at least 2014, while Japanese 2-year government bonds are already extremely low.

The euro rose to a nearly four-month peak of 109.100 yen, well above this year's low of 97.04 yen hit on January 16. It last traded at 108.990, up nearly 2 percent on the day.

(Additional reporting by Julie Haviv)