The euro retreated from two-week highs against the dollar on Monday on worries the euro zone debt crisis could ensnare higher-rated countries, with gloomy economic prospects and rising political risks likely to keep it under pressure.
Analysts said sentiment towards the common currency was bearish, with most investors looking to sell it on any rally before debt auctions this week in Italy and the Netherlands.
The Dutch government was on the verge of collapse after it failed to agree on budget cuts, while Italian bond yields surged as did French borrowing costs after Socialist Francois Hollande - who has promised to renegotiate a European budget pact - won the first round of France's presidential poll.
The euro fell 0.7 percent to $1.3127, holding below Friday's peak of $1.3225, which was logged after a near 1 percent rally in the week, its best since late February. It hovered just above near-term support at its 100-day moving average around $1.3120.
The euro was pressured by data showing German manufacturing unexpectedly shrank at its fastest pace in nearly three years in April. A contraction in manufacturing and services also deepened in the euro zone as a whole.
"It has not been a great start for the week for the euro with German PMI numbers adding to the worries stemming from the political risk factors," said Jeremy Stretch, head of currency strategy at CIBC World Markets.
"If bond spreads continue to widen and stock markets come under more pressure, we could see the euro drop towards $1.3050 rather than head towards $1.3250 in the near term."
Many market participants expect the euro to trade in a range between $1.3000 and $1.3300, with worries about feeble euro zone growth likely to dominate sentiment. But analysts said the euro could fall sharply once it makes a sustained break below strong chart support at $1.30.
"The euro has been above $1.30 for three months now, so a move under $1.30 could bring some more participants in," said Chris Turner, head of currency strategy at ING.
ING forecasts the euro will fall to $1.20 by the end of the second quarter.
The euro, which also lost more than 1 percent against the yen, gained only limited support from a weekend deal to double the International Monetary Fund's firepower to contain the debt crisis.
POLITICAL RISK FACTORS LOOM
Reports said the Dutch government will resign on Monday, paving the way for elections and spelling the end of a coalition which has backed the EU's fiscal treaty.
This sparked concerns that political uncertainty could put into question euro zone states' commitment to austerity measures, coming on top of growing worries about the shaky state of Spain's public finances.
The yield spread on triple-A rated Dutch bonds over German paper moved out to its widest in three years while the Italian debt yield spread also increased. Both the Netherlands and Italy hold bond auctions on Tuesday.
Investors were concerned too that a victory in the French presidential election next month for the Socialist Hollande may loosen his country's commitment to austerity.
The French run-off vote coincides with a parliamentary election in Greece, where support for the two main pro-bailout parties is at historic lows. There is also an Irish referendum on a euro zone fiscal compact agreement on May 31.
The pullback in the euro pushed the dollar index <.DXY> 0.4 percent higher to 79.492. The dollar could gain if Federal Reserve policymakers bring forward their projection on when the Fed should start raising interest rates at its two-day meeting starting on Tuesday, though this is far from assured.
The dollar shed 0.5 percent against the safe-haven yen to trade at 81.09 yen. But yen gains were seen as limited before a Bank of Japan policy meeting on Friday, which is expected to adopt fresh easing steps.
"Dollar/yen is consolidating and any drop to 80 yen is a good level to go long on the dollar for a move to 85 yen," said Stuart Frost, head of Absolute Returns and Currency at fund managers RWC Capital. "We are positioned for that."
Additional reporting by Jessica Mortimer