The euro held near two-month highs on Friday, while the yen was under pressure as investors cut long positions and veered towards high-yielding currencies on improving risk appetite.
The euro was little changed on the day at $1.2684 EUR=, with near term resistance around the May 12 high of $1.2740. It broke past resistance at $1.2673 on Thursday when it advanced nearly 0.5 percent against the U.S. dollar and jumped over 1 percent against the low-yielding yen EURJPY=R.
The euro was supported by a cautiously optimistic European Central Bank, strong European industrial production data and a sizeable drop in U.S. initial unemployment claims.
Clarity on European bank stress tests also helped the euro, as well as bank shares, as investors saw criteria for the checks were no more onerous than markets expected.
Market players are likely to cover more short euro positions, with charts pointing the euro has hit a bottom against the dollar and the yen, said Masahiro Kami, capital market analyst at Sumitomo Mitsui Banking Corp.
At the same time, the euro's rebound may be limited as investors are unlikely to buy back all euro positions they have cut back.
Traders and strategists remained wary about going long on the single currency in a big way, given the fiscal and debt problems that hobble euro zone's economy. In fact, some expect profit-taking and a sell-off soon.
Even though the euro has had a bit of a renaissance, the longevity of these gains is open to question, and is reflected in a wide gap between the one-month and one-year risk reversals, David Watt, senior currency strategist at RBC Capital.
Short-term bearishness has dissipated to some extent, but longer-term markets are still prepared to pay a hefty premium for puts over calls.
Indeed, while 1-month risk reversals EUR1MRR=ICAP have fallen nearly 55 basis points to quote at 0.85/1.35 percent since the end of last month, 1-year risk reversals EUR1YRR=ICAP, have declined by about 25 basis points in the same period.
The European Central Bank on Thursday kept interest rates at a record low 1.0 percent at its monthly meeting. ECB President Jean-Claude Trichet said the economic recovery in the euro area continued in the first half of 2010, although he expected growth to show an uneven pace in an environment of high uncertainty.
He offered few details on whether the upcoming stress tests will effectively gauge the health of European banks. Details on the tests will be disclosed later this month.
The euro stood at 112.30 yen EURJPY=R, hovering near a two-week of 112.52 hit on Thursday, when it jumped more than 1 percent against the Japanese currency.
The yen JPY= was under pressure as investors cut long positions and shifted funds towards high-beta currencies like the Australian dollar AUD=D4 and the New Zealand dollar NZD=D4.
The dollar inched up 0.2 percent at 88.55 yen JPY=, having gained 0.8 percent on Thursday. It has managed to pull away from a seven-month low of 86.94 yen struck on July 1.
Japanese importer demand lifted the dollar against the yen in early trade, traders said.
The yen had made solid gains against the greenback earlier this month on the back of growing worries about an economic slowdown in the United States and falling stock markets .SPX.
But those worries seem to have taken a backseat with some of the gloom lifting due to expectations of strong earnings in the U.S. and thus boosting risk appetite.
The Australian dollar dipped 0.2 percent to $0.8752 on profit-taking, off a two-week high of $0.8792 hit on Thursday. But momentum towards the Aussie was strong given a solid jobs reading which brought back the risk of near term rate increases.
The Australian dollar was steady on the day at 77.46 yen AUDJPY=R, having surged nearly 5 percent this week.
The Obama administration declined to label China a currency manipulator in a report on Thursday, spurring fresh calls from U.S. lawmakers for tough new steps to pressure Beijing.
Traders said Washington's decision had little impact on foreign exchange rates as investors saw the yuan's weakness was no longer an internationally hot issue after China last month freed its yuan from a nearly two-year-old peg to the dollar. (Additional reporting by Anirban Nag in Sydney; Editing by Joseph Radford)