(REUTERS) - The euro gained on Monday, boosted by a broad agreement between France and Germany for tighter control of Eurozone budgets, although gains could be capped if a summit later this week disappoints market expectations.
The accord hashed out between French President Nicolas Sarkozy and German Chancellor Angela Merkel called for automatic sanctions in the event a euro zone member's fiscal deficit falls below 3 percent of its gross domestic product. The agreement will be one of the proposals to be discussed at a European Union summit later this week.
Kathy Lien, director of FX research at GFT in Jersey City, however, remained unconvinced about the euro's gains. She noted that the magnitude of the currency's rally reflected skepticism about European leaders' abilities to provide a tangible solution for the region's debt crisis.
Everyone should take off their rose-colored glasses because this (EU summit) will not be the meeting to end all meetings, Lien said.
Based on the agenda for the EU Summit, the focus will be on greater fiscal cooperation and governance, which would be helpful in the long run but fails to satisfy the appetite of traders who are waiting for any type of monetary commitment.
In late morning New York trading, the euro was up 0.5 percent versus the dollar at $1.34740, holding above last week's low around $1.32300 hit on November 28 and the November 25 trough of $1.32125. The euro hit session highs at $1.34869 on news of the Franco-German agreement, with stop loss orders placed around $1.35000.
Traders, however, said the euro's downtrend seemed intact based on the weekly charts, although it has been able to hold above the weekly lows. On the daily charts, however, the downside looked overextended, and therefore should the euro run into some selling later in the session, the weekly low at $1.32300 could act as support.
Markets earlier cheered Italy's 30-billion-euro austerity package, a mix of tax increases, pension reforms and growth incentives, which the cabinet approved on Sunday. Italian Prime Minister Mario Monti took this measures to the country's parliament on Monday.
In addition, an expected 25-basis-point rate reduction by the European Central Bank on Thursday has been perceived as positive for the euro, some analysts said, as the bank move is seen as necessary to prevent the euro zone from sliding into recession.
Showing just how pessimistic speculators have become on the euro, data from a U.S. financial watchdog on Friday showed speculators on the Chicago futures exchange had their largest net short position in 18 months last week.
The poor state of the euro zone's economy was underlined by business surveys suggesting there will be a steep economic contraction in the current quarter.
Many, however, are hopeful the EU will take a step toward fiscal union by Friday and agree on a treaty change to anchor coercive budget discipline for the 17-nation currency area.
Also firmly in focus this week is an ECB policy meeting on Thursday that is expected to result in a cut in interest rates and fresh liquidity measures for banks, if not more sovereign bond buying.
A Reuters survey of 73 analysts showed a 40 percent chance the ECB will in the next six months start buying government bonds from struggling euro zone economies using freshly created money, which European policymakers have so far resisted.
On Monday, however, the European Central Bank said it slowed its purchases of government bonds sharply last week, as expectations mount that it could be more aggressive in the coming months if euro zone leaders show a willingness to surrender some national powers to save the euro.
The Australian dollar was up 0.8 percent at US$1.0295 ahead of a Reserve Bank of Australia policy meeting on Tuesday, where analysts see a good chance of a rate cut for the second month in a row.
The dollar index .DXY, which measures the performance of the U.S. unit against a basket of currencies, was down 0.5 percent at 78.231.