Against the dollar, the yen weakened to a more than 1-1/2-year low on expectations the Bank of Japan will ease monetary policy at the end of a two-day meeting Thursday. The euro came off its highs against the greenback after the White House made known its displeasure with the opposition Republican plan on the budget, undermining recent tepid progress.
"The fiscal cliff is the issue today as it seems like we're at another state of impasse, so that took a bite out of the euro as risk appetite fell," said Steven Englander, global head of G10 currency strategy at CitiFX. The thin holiday volumes meant there was little follow-through on trades as the day wore on, Englander said, and risk appetite was further undermined as the US stock market reversed early gains to end lower. US President Barack Obama on Wednesday threatened to veto a Republican tax plan because it does not do enough to raise taxes on the wealthy.
If US policymakers do reach a compromise to avert steep tax increases and spending cuts early next year, currencies that tend to gain on a better global growth outlook - like the euro and Australian dollar - should benefit at the expense of the safe-haven dollar.
There is still the chance for the euro to extend its gains further, say analysts, noting year-end demand from corporate and long-term investors in thin trading conditions. Currency speculators are also cutting short euro positions built earlier this year as worries about the euro zone have eased.
On Wednesday, Germany's Ifo survey showed business sentiment rose for a second straight month in December, raising hopes that Germany, Europe's largest economy, will get back on track after stumbling a bit the last few months. The expectations component of the Ifo survey also increased.
"We had good data from Germany, plus we're getting the sense that there is a smooth resolution of the Greek problem," said Vassili Serebriakov, currency strategist at BNP Paribas in New York. The euro rose 0.28 percent to 111.68 yen after hitting 112.49, its highest since August 2011. Investors took out a reported options barrier at 112 yen.
Against the dollar, the single euro zone currency rose as high as $1.3308, its strongest level since early April. By late New York trade, the euro was trading at $1.3233, a gain of just 0.03 percent on the day. The dollar index fell to a two-month low of 79.008 before ricocheting higher in the New York afternoon to 79.320, nearly unchanged on the day.
The dollar rose against the yen to a 20-month high of 84.61 yen as it broke through an option barrier at 84.50. It triggered stop-loss buy orders above that level. The dollar last changed hands at 84.39 yen, up 0.23 percent. Traders reported steady buying of short-dated topside strikes in the dollar/yen options, reflecting the likelihood of more weakness in the yen.
Expectations of looser policy from the BoJ, which tend to weigh on the yen, have been bolstered by the weekend's landslide election victory for Japan's Liberal Democratic Party, which is committed to aggressive monetary easing. Fourteen of 19 economists polled by Reuters last week said they expected the BoJ to ease this week, most likely by increasing its 91 trillion yen ($1 trillion) asset-buying and lending program by up to 10 trillion. Some analysts warned that BoJ measures could fall short of expectations, leading some to buy back the yen.