The euro fell from a one-month high against the dollar on Monday as surging Spanish borrowing costs fueled fears of an escalating eurozone debt crisis and overshadowed a weekend victory for pro-bailout parties in Greek elections.
Spanish bond yields rose above 7 percent, the highest since the euro was launched in 1999, threatening Madrid's ability to finance itself. Greece, Ireland and Portugal were forced to seek international bailouts soon after their 10-year bond yields rose above 7 percent.
Although Sunday's vote eased immediate concerns about Greece being forced out of the eurozone, the narrow victory raised doubts over how the winning New Democracy party would implement deep spending cuts and tax increases that come with the bailout.
Market players also fretted about the eurozone's ability to respond to the risk of contagion to larger economies like Spain and Italy, with investors likely selling into any near-term bounce by the euro.
"Lots of focus on the Greek election today, but in the scheme of things, it is noise," said Jens Nordvig, global head of FX strategy at Nomura Securities in New York.
"Spanish yields have shot through the highs from November, and even the short-end is now looking shaky. Europe is facing much greater challenges than the risk of a Greek exit," he said.
Nordvig said the instability of the eurozone as a whole had started to cause capital flight and only a fundamental reform of the bloc would stop it.
The euro was down 0.5 percent at $1.2576, off a one-month high of $1.2747 hit in Asia as it came under pressure on reported selling by Asian sovereign investors. It was the euro's worst showing in nearly three weeks.
Investors are shifting focus to a policy announcement by the Federal Reserve on Wednesday. Some analysts said the euro could gain versus the dollar on speculation the U.S. central bank may opt for more easing to boost growth.
Many market players expect the Fed to extend its long-term bond-buying through Operation Twist by a few months from the current deadline of June after a series of disappointing data.
Citigroup, for one, expects a modest extension of Operation Twist by $200 billion, although it may not have as much risk-positive impact as the two rounds of quantitative easing.
The dollar rose 0.5 percent to 79.09 yen. The euro was little changed at 99.48 yen.
Spain is likely to pay record high borrowing rates at debt auctions this week. Spain's Treasury will issue 2 billion to 3 billion euros ($2.52 billion-$3.79 billion) of 12- and 18-month debt on Tuesday and between 1 billion and 2 billion euros of bonds due in 2014, 2015 and 2017 on Thursday.
The euro also failed to hold gains given that the positive Greek election outcome had already been priced in last week. Greek equities had rallied 14.1 percent between Tuesday and Friday. The euro rose from roughly $1.25 to $1.2650 and the S&P 500 rallied 2.5 percent in the same period.
The Greek parties that broadly back the country's international bailout will agree to form a coalition government on Tuesday, a senior official with the conservative New Democracy party that won the election told Reuters.
A source said Greece will ask the so-called "troika" -- the European Union, European Central Bank and International Monetary Fund -- to spread 11.7 billion euros in austerity cuts over four years instead of two.
However, German Chancellor Angela Merkel said Germany cannot accept any loosening of the terms of Greece's bailout. A senior eurozone official said international partners will not decide on fresh loan payments to Greece until a new government there has signed a memorandum of understanding with the troika.
Howard Jones, adviser at RMG Wealth Management, said any rebound to $1.28 in euro/dollar is a selling opportunity.
Positioning data showed speculators' massive net euro short positions at 195,187 contracts last week, even after they were trimmed from the previous week's record high of 214,418 contracts.
In the options market, near-term implied volatility fell, with the one-week easing to 11.45 percent from a high of around 16.75 percent last Thursday, while the one-month dropped to a roughly four-week low of 11.26 percent.
However, one-month risk reversals still pointed to a bias for euro weakness.
European finance ministers meet on Friday and a summit is scheduled for the end of this month, but little is expected in the way of fresh policy measures toward a banking union or greater fiscal integration like common euro bonds.
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