(Reuters) - The euro dipped against the dollar on Wednesday as a short-squeeze rally from the previous day petered out, with some market players cautious of buying the single currency ahead of a German government bond auction later in the session.
Market players said the euro was meeting resistance after posting its biggest one-day rally in nearly two months on Tuesday, when investors trimmed bearish positions in the common currency following upbeat data that bolstered risk appetite.
Euro zone economic data on Wednesday tempered some of that optimism. The latest set of purchasing managers' indexes (PMIs) suggested the region is firmly on course for a moderate recession, even though the composite PMI reading was slightly better than expected.
The single currency slipped 0.1 percent to $1.3032, with good bids cited around $1.3020-25. Traders also reported a large digital option expiry at $1.3115 that could prove magnetic later in the session.
Many analysts expected the auction of 5 billion euros of 10-year Bunds to go smoothly, but said some investors may be reluctant to buy the euro given poor demand at a similar sale in November.
While decent demand at Wednesday's auction is unlikely to boost the euro significantly, a poor auction could prompt euro selling on concerns the euro zone debt crisis is starting to undermine Germany's safe haven status.
We would expect the auction to run well, that means it will not have any positive impact on the euro, said Lutz Karpowitz, currency analyst at Commerzbank.
There are a lot of short positions in the euro so a retracement like the one we saw yesterday was nothing unusual but it will come to an end because the problems in the euro zone are still unsolved.
The euro rose to a one-week high of $1.3077 in the wake of a better-than-expected U.S. manufacturing report on Tuesday, with gains fuelled by short-covering. Data last week showed currency speculators had boosted bets against the euro to a record high in the week ending December 27.
Still, many investors remained quite happy to keep big euro short positions, and the euro has failed to break above its 21-day moving average around $1.3078 for now.
Against the yen, the single currency was at 100.03 yen, holding above the decade low of 98.71 hit in holiday-thinned trade on Monday.
EURO OUTLOOK SHAKY
Portugal, a euro zone sovereign that has already received a bailout, will also sell up to 1 billion euros of three-month T-bills on Wednesday.
Analysts said a better indication of investor appetite to buy euro zone government debt will come at a French bond auction on Thursday, and Spanish and Italian debt sales next week.
Markets are particularly concerned about Italy's ability to cover around 100 billion euros of redemption and coupon payments in the first four months of the year.
Traders are also looking ahead to the meeting of French President Nicolas Sarkozy and German Chancellor Angela Merkel on January 9 to see how much progress Europe can make on their pledge for tighter fiscal integration.
Most market players said the outlook for the single currency looked bleak given a difficult economic backdrop in Europe.
We think that the downward trend in EUR/USD will likely remain intact in the medium term unless euro area economic activity stabilizes overall and/or the U.S. economy shows a marked slowdown - neither of which is our central scenario, Yuki Sakasai, an analyst at Barclays Capital wrote in a note.
Any rebound in EUR/USD may provide a better entry level for a strategic medium-term short EUR position, in our view.
Euro zone flash inflation data due later in the session is expected to drop to 2.8 percent in December from 3.0 percent previously.
With the euro steady ahead of the German auction, the dollar index .DXY was little changed at 79.752. The greenback gained slightly against the yen, edging up to 76.69 yen, not far from a record low of 75.311 marked late last year.
Commodity currencies slipped as players took profits from the Aussie's latest climb to a record high against the euro.
The euro edged up to A$1.2596 on Wednesday after falling to a record trough of A$1.2564 on Tuesday. That helped knock the Aussie to $1.0339 versus the greenback, off Tuesday's two-month high of $1.0387.