(Reuters) - The euro held above a two-month low versus the dollar on Tuesday but was seen vulnerable to further selling as the threat of euro zone sovereign downgrades hung over the currency and kept investors wary.
Short covering helped the euro rebound modestly after it failed to break below a reported barrier at $1.3150, but traders said there remained a clear bias to sell on any bounce.
The single currency was up 0.1 percent at $1.3200, having hit its lowest since early October at $1.3160 on trading platform EBS in the Asian session. Option-related bids were reported ahead of $1.3150, with support at the October low of $1.3145.
Traders highlighted short-term stop-loss orders at $1.3250 and good selling interest above. Against the yen, the euro slipped to a two-month low of 102.42 on EBS before steadying at 102.75.
Investors took some encouragement from lower yields at an auction of Spanish short-term debt, while a survey showed German investor sentiment rose unexpectedly in December though worries about the severity of the region's debt crisis remained.
Comments from France's candidate for a seat on the European Central Bank's Executive Board, Benoit Coeure, who said the ECB may need to step up its bond-buying to help reduce borrowing costs for some states, were also euro-positive.
The Spanish auction was reassuring but there is still an Italian auction to come this week and the market will be inclined to push the euro lower from here, said Audrey Childe-Freeman, EMEA head of currency strategy at JP Morgan Private Bank.
The only thing that would be enough to restore confidence for now would be aggressive bond buying by the ECB, she said, though repatriation flows could support the euro heading into year-end.
Moody's said on Monday it intends to review the credit ratings of all 27 European Union states in the first quarter of 2012, while another ratings agency, Fitch, said pressure on their ratings had risen after last week's EU summit yielded no comprehensive crisis solution.
Standard & Poor's, the other major rating agency, already has 15 euro zone states on watch for a possible downgrade.
The last blow for the euro was the announcement from the ratings agencies last night, said Niels Christensen, currency strategist at Nordea in Copenhagen.
The technical configuration is turning against the euro. If it breaks below the early October lows then very quickly $1.30 would be in the frame, plus we have thin markets. It all adds up to a clear bias to the downside for euro/dollar.
Although IMM speculative positioning data suggested strongly negative sentiment towards the euro, the single currency could gain short-term support as investors take profits on or cover those positions.
Some support was also garnered from a solid start to the new short-term debt issuance program of the European Financial Stability (EFSF) Bailout Fund, which sold nearly 2 billion euros of three-month bills at a yield of 0.22 percent.
FALLING RISK APPETITE
Pressure on the euro and heightened risk aversion increased the dollar's safe-haven appeal, lifting the dollar index .DXY to 79.651, its highest this month, before it dropped back to 79.478.
Later on Tuesday, the Federal Reserve holds its final policy meeting of the year but it is not expected to take any action other than some finishing touches to its communication strategy. Many analysts expect the Fed to wait until a two-day meeting on January 24-25 before launching any new initiatives.
U.S. retail sales data will be released ahead of the Fed meeting.
The risk-sensitive Australian dollar was up 0.4 percent at $1.0118, having earlier shed more than 1 cent to a two-week low of $1.0030.
Market liquidity was thin ahead of year-end holidays, which may hurt demand in sales of Italian and Spanish bonds on Wednesday and Thursday. Weak results would add to pressure on the euro.