Euro drops to 2-week low with EU summit ahead

A picture illustration of crumpled kuna, Dollar and euro banknotes, taken in Zagreb January 18, 2011.

NEW YORK (Reuters) - The euro fell to its lowest against the dollar in more than two weeks on Tuesday as Spanish bond yields rose and hopes faded that a European summit would make progress in resolving the region's debt crisis.

But further losses could be limited ahead of the meeting, which takes place on Thursday and Friday, as expectations for it were already low, analysts say. An unexpected positive outcome could spur a short squeeze in the euro by some speculators, although traders are likely to sell into any bounce.

The prospect of a quick move toward a banking union or issuance of common euro-zone bonds looked increasingly unlikely, with German Chancellor Angela Merkel describing moves to share debt liability as "counter productive.

Merkel was also quoted as telling a meeting of one of the parties in her coalition on Tuesday that Europe would not have shared total debt liability "as long as I live.

"The euro is going to trend lower, but I don't think you're going to see any large moves ahead of the summit," said John Doyle, senior strategist at Tempus Consulting in Washington.

"I don't think, realistically, that anyone is expecting a magic bullet to come out of this meeting and to fix all the underlying problems in Europe."

The euro fell as low as $1.2440 according to Reuters data, the weakest since June 8, after earlier reported sovereign demand faded. It came off the day's low to trade at $1.2497, down 0.1 percent, but analysts said that was positioning ahead of the summit. The next downside target lies near the June 1 two-year low of $1.2286.

"Nothing is going to come out of the EU summit," said Christopher Vecchio, currency analyst at DailyFX in New York. "It looks like short covering. It's a dead cat bounce."

The euro zone's debt problems showed no signs of abating, with Cyprus becoming the fifth euro-zone country to request help as its banks have been hit hard by exposure to debt-crippled Greece.

Spain's short-term borrowing costs nearly tripled at an auction on Tuesday, a day after the country formally requested a European bank rescue and Moody's cut the ratings of most Spanish lenders..

And Italy offered up to 2 billion euros on Tuesday to plug a capital gap in the bank Monte dei Paschi di Siena, the second time in three years the cash-strapped state has had to bail out the world's oldest bank.

Against the yen, the euro slipped 0.3 percent to 99.31 after hitting 98.71, also a two-week low. The euro also dropped against sterling to its lowest since the end of May.

UBS said scepticism about the euro was reflected in the bank's latest flow monitor, which showed their clients continued to add to short euro positions last week, while overseas investors offloaded a net $2 billion worth of euro-denominated equities, the most since July 2008.

SHOWDOWN IN TOKYO

The risk of disappointment from another euro-zone summit and risk aversion supported the Japanese yen and helped it pull away from a near two-month low against the dollar.

The dollar fell 0.3 percent to 79.46 yen, off an eight-week high of 80.59 hit on Reuters data on Monday.

But analysts said the yen could struggle as political uncertainty gripped Japan. The country's lower house approved a plan to double the sales tax to help curb the snowballing national debt, although the vote split the ruling Democratic Party.

"The threat of heightened political uncertainty may weigh upon the yen in the near-term although it is more likely to be offset by ongoing negative developments in Europe, which are still fuelling safe-haven demand for the yen," Lee Hardman, currency economist at Bank of Tokyo Mitsubishi in London, wrote in a note.

Some market players think the yen may come under pressure if a large number of ruling party lawmakers revolt against Prime Minister Yoshihiko Noda's tax hike plan, which could force him to call an early election.

(Reporting by Nick Olivari and Wanfeng Zhou; Editing by Jan Paschal)