Euro rallies on Greece deal, debt impasse hurts dollar

(Reuters) - The euro rallied to a two-week high against the dollar in Asia on Friday after euro-zone officials gave their financial rescue fund sweeping new powers to solve Greece's debt troubles, easing fears that the country's debt crisis would spread.

The dollar was punished across the board as the encouraging news out of Europe contrasted with confusion over how much progress Washington is making to avoid a U.S. default.

"Europe has made a big stride after all while the U.S. is still dragging its feet on the debt ceiling. That's why the dollar is under pressure now," said a dealer at a Japanese bank in Tokyo.

Markets cheered the package as it was more ambitious than some had expected earlier this week. The euro climbed to a two-week high of $1.4440 before steadying around$1.4390.

The euro is around the level of the 50 percent retracement of its decline from early May until last week, in which worry about the euro zone debt crisis played a big role.

European leaders have agreed on a bailout package that would make it easier for Greece to reduce debt more sustainably by easing terms of loans and by making Greek bond investors shoulder some of the burden.

As these measures are likely to prompt credit rating firms to declare Greece to be in temporary default, the leaders also made provisions to protect Greek banks from the fallout, by providing credit guarantees if needed to ensure they can still obtain liquidity from the European Central Bank.

The region's rescue fund, the European Financial Stability Facility, will be allowed to buy bonds in the secondary market if necessary and also to lend governments money to recapitalize banks.

"The package has made it difficult to make speculative attacks on the euro. But they were vague on increasing the size of the bailout fund. That's one weak point," said another trader at a Japanese bank.

Euro bears say it is yet to be seen if the measures can stabilize other indebted countries and stave off contagion to the currency bloc's bigger economies.

Still, it was enough to prompt short-covering in the euro.

"It's probably not a long-term solution but it provides some clarity ... At the end of the day it doesn't address key issues, but it will contain contagion," said Grant Turley, a strategist at ANZ in Sydney.

The common currency could target around $1.4455, where charts show an Elliot wave equality target as well as the top of the Ichimoku cloud, and then $1.4520, a 61.8 percent retracement of its decline since May.

Implied volatilities on euro/dollar options dropped as fears receded that disappointment over the summit could pummel the euro. One-month volatility fell to below 12 percent from above 13 percent before the summit.

The single currency also rose to around 1.1765 Swiss francs, 3.5 percent above the record low of 1.1365 francs hit at the start of the week.

DOLLAR INDEX BELOW TRENDLINE

As the euro recovered, the dollar index .DXY wallowed near a six-week low after posting its biggest daily drop of the year on Thursday.

The index stood at 74.096, near Thursday's low of 73.889, having clearly broken below its trendline support since May.

The U.S. currency also slipped to a four-month trough of 78.22 yen, the lowest since joint G7 intervention in mid-March, before recovering to 78.58 yen.

Still, few traders think Japan is ready to intervene in the near future, in part because the yen is still off recent peaks against most currencies except the dollar.

Japanese margin traders have a huge long position in the dollar, which means any intervention would likely only invite their profit-taking and have a limited impact.

Pricing of dollar/yen options also suggested limited expectations of Japan's intervention with scant demand for yen puts, whose value would gain sharply in the event of yen selling intervention.

Their risk reversal spreads, which measure the price gap between yen calls and yen puts, rose to the highest level in four months in favor of yen calls, pointing to limited demand for yen puts.

That contrasts with the days following Japan's intervention last September, when many market players bought yen puts for hedging.

While an enlivened risk appetite after the euro-zone debt deal and the entrenched perception that U.S. monetary policy will remain loose for the foreseeable future are the main damper on the currency, some traders say the dollar was not helped by uncertainty over wrangling in Washington on the debt ceiling.

Efforts to craft a $3 trillion deficit-reduction deal gained traction on Thursday, but the White House and Republicans have not broken their impasse over higher taxes. Tax hikes are opposed by the Republicans, who control the lower house.

Although most market players expect some sort of deal by the August 2 deadline to raise the $14.3 trillion debt ceiling and avoid default, some worry that failure to reach a major deficit reduction plan could lead to a credit downgrading.

As the U.S. dollar wilted, the New Zealand dollar stayed near a 30-year high of $0.8643 hit on Thursday while the Canadian dollar also remained near a 3 1/2-year high of C$0.9424.