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* Euro retreats from seven-week high versus dollar
* Talk of European central bank diversifying out of euro
* Euro zone policymakers seen making slow progress
NEW YORK, Aug 24 (Reuters) - The euro fell against the dollar on Friday after Thursday's rally to a seven-week high, as investors debated the outlook for the currency and how close policymakers really are in tackling the European debt crisis.
Sources told Reuters on Thursday Spain is in talks with euro zone partners over conditions for aid to bring down its borrowing costs, though the country has not made a final decision to request a bailout.
While this implied there would be no rapid progress in resolving Spain's debt problems, some strategists said the talks are positive for the euro as they could open the door for the European Central Bank to intervene in the bond market.
The euro remained pressured after German Chancellor Angela Merkel said on Friday after meeting Greek premier Antonis Samaras in Berlin that Germany would not judge his country's performance on its reform targets prematurely, but would await a report by the "troika" of international lenders due next month.
Greek Prime Minister Antonis Samaras said his country does not want more money from its euro zone partners, just time to breathe so that it can return to growth. Investors had already expected little discussion of flexibility on Greek austerity measures before September.
"The euro is softer across the board as German Chancellor Merkel hosts Greek Prime Minister Samaras in Berlin," said Eric Viloria, senior currency strategist at Forex.com. "Merkel indicated that the talks with Samaras were a 'good beginning', but won't make a premature judgment on Greece until the Troika report."
The euro has rallied strongly this week on speculation the ECB will unveil plans to help lower Spanish and Italian bond yields at its next policy meeting on Sept. 6.
Viloria noted that Spanish 10-year yields are higher after the European Union reiterated it has not received a request for a full bailout from Spain and that it remains focused on bank aid for the country.
The euro was last trading at $1.2508, down 0.4 percent and below Thursday's peak of $1.2589, its highest since early July. Despite Friday's losses, it has gained 1.4 percent this week, its best weekly performance on a percentage basis since February 26 at current prices.
"After three particularly good days it would not surprise me today if we have a bit of a pullback to get better levels to buy in," said Daragh Maher, currency strategist at HSBC.
"The market still seems to be a bit more optimistic - or at least a bit less pessimistic - on the euro and we've been getting a slow but relentless closing of shorts."
Maher said with little obvious near-term technical resistance the euro could extend its short squeeze higher to $1.27 before the next ECB meeting, as investors who earlier bet against the single currency closed their positions.
The common currency also lost ground against the Swedish crown and the British pound on talk of selling by a European central bank that has been actively diversifying its euro holdings into other currencies.
Some strategists said the euro is likely to trade in a $1.23-1.27 range in the coming weeks as investors gear up for crucial developments next month.
After the ECB meeting on Sept.6, there are Dutch elections and a German Constitutional Court ruling on the euro zone rescue fund on Sept. 12 and an EU finance ministers' meeting starting on Sept. 14.
"It is not a bullish euro story given all the events next month. But the U.S. is not looking good either. So we are looking at buying other currencies like the Swedish and Norwegian crown and selling the euro," said Stuart Frost, head of Absolute Returns and Currency at fund managers RWC Capital.
The dollar was flat at 78.49 yen.
The Australian dollar fell to a four-week low against the U.S. dollar, hurt by concerns over slowing growth in China and continuing debate whether the country's mining boom was coming to an end.