NEW YORK (Reuters) - The euro rose to a four-month peak against the dollar on Wednesday after Germany's Constitutional Court approved the euro zone's new rescue fund, leaving currency sentiment to hinge on an upcoming Federal Reserve stimulus decision.
While the German court approval came with conditions it nevertheless allayed fears about the region's three-year-old debt crisis and helped lower borrowing costs for Italy and Spain, the euro zone's third- and fourth-largest economies, respectively.
With the court decision out of the way, the dollar's direction will be dictated by whether the Fed announces a third round of quantitative easing, dubbed QE3, at the conclusion of its two-day meeting on Thursday. The program is tantamount to printing money and dilutes the value of the dollar.
The Fed looks set to launch a third round of bond purchases to try to drive U.S. borrowing costs lower and boost a flagging economy, especially after weak jobs data last week.
"If the Fed announces QE3 we will likely see a knee-jerk move lower in the dollar, but it should be modest because at this stage it is priced into the market," said Joe Manimbo, senior market analyst at Western Union Business Solutions in Washington D.C.
"On the other hand, the dollar could see a relief rally if the Fed disappoints and personally I think they will save their firepower with all the looming event risk we have ahead, such as the U.S. fiscal cliff," he said.
The U.S. fiscal cliff is the term being used to describe a series of tax rises and spending cuts that are set to kick in at the beginning of next year.
The euro climbed to $1.2936, its highest since mid-May, blowing past reported option barriers at $1.2900. Positive momentum for the euro has been in place since the European Central Bank unveiled plans last week to lower borrowing costs for indebted countries via bond purchases. In September, the euro has gained in six out of eight sessions.
The euro has risen more than 7 percent since it hit a two-year low of around $1.2040 in July, boosted after ECB President Mario Draghi pledged to do whatever it takes to preserve it.
"The euro continues to be in steady favor as a series of events have proven to be supportive, including today's ruling by Germany's top constitutional court," said Samarjit Shankar, managing director of global strategy at BNY Mellon in Boston.
Germany's Constitutional court said the European Stability Mechanism could go ahead but with the condition that any German contribution above 190 billion euros would require prior approval by the lower house of parliament.
The euro was last at $1.2894, up 0.3 percent.
It also rose to its highest in more than two months against the yen at 100.63 yen and last traded at 100.38 yen, up 0.5 percent.
A potential source of disruption for the euro is a general election in the Netherlands on Wednesday, though polls indicate radical anti-euro parties have lost the momentum they had just a month ago.
The dollar fell to a four-month low against a basket of currencies before Thursday's Fed decision, with the dollar index .DXY dropping to 79.522.
BNY Mellon's flows data showed that the dollar was the most sold currency across the board on Wednesday, with sterling and the Canadian and New Zealand dollars the most bought.
The Swiss National Bank is expected to keep its target range for the Swiss franc LIBOR unchanged and retain its cap on the euro/Swiss franc currency pair at 1.20 francs when it announces its monetary policy decision on Thursday.
Against the yen, the dollar traded up 0.1 percent at 77.84 per dollar. Focus on potential Fed action this week and a Bank of Japan viewed to be on the sidelines should keep pressure on the dollar for the near term.
Additional reporting by Gertrude Chavez-Dreyfuss; Editing by James Dalgleish