NEW YORK (Reuters) - The euro edged higher against the dollar on Monday after two days of losses, lifted by euro zone data showing business activity picked up, while uncertainty over the Federal Reserve's economic stimulus program kept investors wary of the greenback.
The Fed goes into a two-day meeting starting on Tuesday and market participants have started to price in the possibility that it will opt for a small reduction in its bond purchases.
That resulted in a stronger dollar trend last week, but Vassili Serebriakov, currency strategist at BNP Paribas in New York, said much of the dollar-buying has been done.
"There's no reason to buy the dollar ahead of the Fed decision and so this is just position adjustment," he said, adding that BNP expects the Fed to start scaling back its asset purchases in March.
"In the meantime, we continue to scratch our heads about the euro's strength. I guess the euro is being lifted by year-end factors - liquidity has tightened in the euro zone with European banks paying back loans owed to the European Central Bank. That has pushed up short-term interest rates."
The euro rose to just shy of $1.38 after a report on Monday showed German manufacturing activity and the Flash Eurozone Composite Purchasing Managers' Index both beat forecasts in December. It was last at $1.3766, up 0.2 percent on the day.
The single currency had earlier dipped to around $1.3745 after separate data showed French private-sector activity unexpectedly slowed.
It trimmed some of its gains after ECB President Mario Draghi, speaking before the European Parliament on Monday, highlighted the euro zone economy's downside risk, affirming that interest rates in the region will stay low, if not lower, for longer. The euro was last up 0.1 percent at $1.3756.
The dollar index .DXY, meanwhile, fell 0.2 percent to 80.072, consistent with lower U.S. Treasury bond yields on Monday.
Market participants, in general, do not expect the Fed's rate-setting committee to make any major policy change when it meets on Tuesday and Wednesday. [ID:nL1N0JQ0SB] But most recent U.S. data suggest the Fed will begin to wind down its bond-buying program sooner rather than later.
Jens Nordvig, head of G10 FX strategy at Nomura Securities in New York, said that if the Fed decides to taper this week, the impact on the market will not be as dramatic as in May and June, when investors started pricing in a reduction in the Fed's quantitative easing.
"Much will depend on whether tapering is combined with enhanced forward guidance," said Nordvig. "Bottomline, risk assets may trade fairly well, despite taper, and in FX we would look to buy dollar/yen again, ideally on a dip."
Highlighting nervousness in the market, euro/dollar one-month implied volatility, a gauge of how choppy a currency pair is likely to be, rose to its highest in five weeks at 7.11 percent.
The euro has risen in recent weeks, tracking higher euro zone money-market rates. As euro zone banks repay cheap loans to the European Central Bank, the ECB's balance sheet should shrink, putting further upward pressure on rates. In contrast, the Fed, for now, and the Bank of Japan are printing vast sums, weakening the dollar and the yen.
The yen rose as investors bought the safe-haven currency after tepid Chinese manufacturing data fueled concern about recovery in the world's second-largest economy. An uptick in Japanese business sentiment supported the yen at the margins, but most analysts said the gains would probably not last.
"The central bank is printing money and the majority of analysts even expect it to increase the volume of bond purchases in 2014," Lutz Karpowitz, currency strategist at Commerzbank, wrote. "The yen has everything required to come under further pressure, and Tokyo also welcomes a weak yen."
The dollar fell 0.2 percent to 102.98 yen.
The euro was little changed at 141.73 yen, off a five-year high of 142.82 yen hit last week.
Data from a U.S. financial watchdog showed speculators' net yen short positions were near six-year highs last week.