(REUTERS) -- The euro rose against the dollar on Tuesday, supported by expectations that a Greek debt restructuring deal could be clinched soon to help avoid a messy default, while a resurgent yen kept alive the risk of intervention by Japanese authorities.
The dollar extended its recent losses against the yen to hit a three-month low, under pressure after the U.S. Federal Reserve said last week it was likely to keep interest rates near zero at least until late 2014.
The euro got a lift after Greek Prime Minister Lucas Papademos said negotiators had made significant progress in talks to strike a restructuring deal on government debt, with the aim of a definitive agreement by the end of this week. But gains were likely to be tempered as worries mount that Portugal could follow Greece into debt restructuring.
The common currency, which is on track for its best monthly performance October, was up 0.5 percent at $1.3190, having risen to as high as $1.32138, not far from a six-week high of $1.3235 hit last week on trading platform EBS.
The euro faces resistance at that level and also near $1.3244, the 38.2 percent retracement of its Oct-Jan slide.
I don't think the euro will hold on to gains above $1.3200-1.3250 as investors are not keen to squeeze out euro shorts, said Sebastien Galy, FX strategist, at Societe Generale.
The market is currently keeping aside the various risk factors like the possibility of a Portuguese debt restructuring on hopes of more liquidity injection by major central banks.
Apart from the U.S. Federal Reserve keeping the door open for more quantitative easing, expectations are rising that the European Central Bank could pump in huge amount of funds through the next long-term refinancing operation to be held in February.
A Reuters poll showed traders expect the ECB to allot 325 billion euros ($428.24 billion) at the tender and this is likely to support riskier assets like stocks and commodities in coming weeks.
A rise in global stock markets weighed down the safe-haven U.S. dollar and lent support to the euro, traders said, adding there was also talk of the potential for dollar-selling related to month-end portfolio adjustments.
With global stock markets as measured by the MSCI index gaining almost 6 percent in January, investors are overhedged on their portfolios and need to rebalance it by selling dollars into the month-end.
Analysts said while an agreement to avoid a disorderly Greek default would lift sentiment in the short term, the risk of the crisis ensnaring the euro zone's larger economies will keep investors bearish about the euro in the medium term.
The euro apart, the dollar was also under pressure against most currencies and was down 0.4 percent against a basket of currencies at 78.842. The index had fallen to a 7-week low of 78.741 earlier.
Against the yen, the dollar hit a three-month low of 76.175 yen on trading platform EBS at one point, well below last week's high of 78.288 yen. The dollar was last trading flat on the day at 76.32 yen.
Traders cited talk of dollar bids down towards 76.00 yen, and stop-loss dollar offers at levels below 75.80 yen or so.
Japanese Finance Minister Jun Azumi vowed to take firm steps against excess volatility and speculative moves in the foreign exchange market to curb any renewed rises in the Japanese currency.
But strategists at Morgan Stanley reckoned the flows were far from speculative. They said the latest demand for yen was from Japan's institutional investors off-loading the FX risk of their $2.6 trillion foreign bond holdings.
Japanese-based investors have hedged about $1.6 trillion of these holdings. As long as hedging costs stay low, we believe that these investors will continue to off-load FX risks, keeping the yen strong, they said in a note.
A Reuters poll showed Japanese fund managers were keen to return funds to Japan as they saw Tokyo shares relatively undervalued while they cut their North American stock weightings.
As such, not many expect yen-selling intervention by Japanese authorities, although market wariness is likely to rise if the dollar drops down to around 75 yen.
Dollar/yen implied vols were higher along the curve as markets priced in possible turbulence in coming days. One-month traded around 7.95 percent versus 7.25 on Monday, with one-year vols at 10.90 percent versus 10.70.
Risk-reversals, though, were steady, with the one-month around 0.35 for dollar calls against 0.30 Monday.