Euro supported by short squeeze

One hundred Euro banknotes lay on top of various Swiss Franc notes in this picture illustration at a bank in Warsaw, July 18, 2011.

SYDNEY (Reuters) - The euro held on to overnight gains in Asia on Wednesday, having posted its biggest one-day rally in nearly two months as investors cut bearish positions in the common currency after upbeat data bolstered risk appetite.

The euro gained as much as 0.9 percent to reach its highest in a week at $1.3076 in the wake of better-than-expected U.S. manufacturing report on Tuesday. It last stood at $1.3048, well off a 15-month trough around $1.2858 plumbed last week.

The U.S. data came on the back of a survey on Sunday showing a slight expansion in China's business activity, all of which helped ease the market's worst fears about the global economy.

Further aiding the euro, minutes from the U.S. Federal Reserve's December meeting were construed by markets as dollar-negative.

The Fed said it would begin publishing forecasts on the path of interest rates later this month, a move that could suggest rates will be on hold for longer than previously expected.

Traders said a break above the 21-day moving average at $1.3075 is seen likely to see the euro rise towards the December 21 high near $1.3200.

Against the yen, single currency was at 100.12, pulling up from a decade low 98.71 hit in holiday-thinned trade on Monday.

Traders said the near-term risk is for a further short squeeze in the euro, given the significant net short positions put on the single currency recently. Data last week showed currency speculators had boosted bets against the euro to a record high in the week ended December 27.

Still, the outlook for the common currency remained shaky at best due to worries about the euro zone debt crisis. Market focus is squarely on a bond auction by Germany later on Wednesday. Portugal will also sell up to 1 billion euros of three-month T-bills.

"We think that the downward trend in EUR/USD would likely remain intact in the medium term unless euro area economic activities stabilize overall and/or the U.S. economy shows a marked slowdown - neither of which is our central scenario," said Yuki Sakasai, analyst at Barclays Capital.

"Any rebound in EUR/USD may provide a better entry level for a strategic medium-term short EUR position, in our view."

The rebound in the common currency saw the dollar index .DXY slide to two-week lows at 79.518. The greenback also lost ground against the yen, falling to 76.59 yen, not far from the record low 75.311 hit late last year.

All these factors gave commodity currencies a huge boost with the Australian dollar bouncing towards $1.0400 -- its highest since early November -- well off last week's lows near parity. The Aussie also hit a record high against the euro on Tuesday.

But heavy resistance seen around $1.0400 could limit the Aussie's upside for now.