The euro rose versus the dollar on Friday, moving away from a one-month low and finding support after Italy approved austerity measures, but the precarious situation in the euro zone left the currency vulnerable to renewed selling.
The euro held on to earlier gains after the Italian Senate backed a new budget law, clearing the way for final approval in the lower house on Saturday and the formation of an emergency government.
The euro was up 0.2 percent at $1.3630, holding above Thursday's one-month low of $1.3484, with traders citing demand from Middle East accounts. But gains were limited by offers above $1.3700.
Euro selling pressure eased on signs of political stability in Italy and Greece, with former European Commissioner Mario Monti the favourite to replace Italian premier Silvio Berlusconi. In Greece, prime minister-designate Lucas Papademos will name a crisis cabinet to roll out austerity plans.
The FX market needs to see confirmation that Monti will take over and that Italy will commit to implementing the fiscal measures that are necessary. If that is the case it would give the euro a bit of relief, said Audrey Childe-Freeman, EMEA head of currency strategy at JPMorgan Private Bank.
But we are far from being out of the woods yet and there will be continued question marks and volatility in FX markets over the next few weeks.
A break below Thursday's low could leave the euro targeting the early October low of $1.3145. Before that, support lies around $1.3405, the 76.4 percent retracement of the euro's $1.3145 to $1.4248 rally.
The euro is on track to end the week around 1 percent lower, a relatively limited loss in a week of choppy trade which saw the currency lose 2 percent on Wednesday, its worst daily performance since August 2010 ,according to Reuters data.
A partial U.S. market holiday was seen subduing market movements on Friday.
Stephane Monier, head of fixed income and currencies at Lombard Odier in Geneva said that in recent weeks he had further cut positions in the euro and Swiss franc in favour of safer currencies.
In terms of what we consider safe-haven currencies in the short run, apart from the dollar, which could also benefit from political risk in the Middle East, we are positive on the Norwegian crown, the yen, and maybe sterling, Monier said.
He said had become overweight in those currencies in the past six weeks, after becoming increasingly short on the euro since summer, and going underweight Swiss francs after the Swiss National Bank has successfully limited the franc's rise.
His firm has $36 billion in assets under management, $16 billion of which are invested in fixed income assets.
Market positioning in options suggests investors are bracing for a further slide in the euro, with euro/dollar one-month risk reversals trading at extreme levels around 4 in favour of euro puts -- bets on euro falls.
Some traders said hedge funds have bought euro puts with strikes around $1.26 that are due to expire in six weeks.
The dollar fell 0.4 percent against the yen to 77.38 yen , having dropped as low as 77.32 yen, the lowest since Japan's massive yen-selling intervention on Oct. 31. Market sources have told Reuters that Japan has probably conducted more intervention since then.
Both the dollar and the yen are considered safe-haven currencies in times of market stress, but speculation that the U.S. Federal Reserve may eventually launch another asset-buying programme, or QE3, has weighed on the dollar.