The euro rose against the U.S. dollar after the European Central Bank announced plans to start accepting a wider range of collateral in its lending operations and also assets of a lower quality, a move designed specifically with Spain's woes in mind.
Earlier, the euro had slipped to its lowest in nine days against the dollar as wariness set in ahead of an European leaders meeting later in the day and a German business confidence survey that is likely to disappoint.
Friday's meeting between German, French, Italian and Spanish leaders will search for ways to achieve fiscal and banking union in the euro zone and, more urgently, it may also be the occasion for Spain to formally request assistance of up to 100 billion euros for its struggling banks.
The euro [EUR=X 1.2555 0.0009 (+0.07%) ] rose 0.2 percent against the U.S. dollar to $1.2575.
The dollar index [.DXY 82.29 --- UNCH ] fell 0.1 percent to 82.18 after posting its highest level since June 13 and having rallied nearly 1 percent in the previous session.
Overnight, the dollar staged its biggest rally in more than three months after key surveys of business activity from China to the euro zone and the United States darkened the outlook for the world economy.
"The data everywhere is quite bleak," said Steve Barrow, currency strategist at Standard Bank. "While the focus is still on the euro zone, we have the UK in a recession, the euro zone nearly there, all of which could spillover and drag the U.S. and China lower. In that kind of a scenario, investors will head into the U.S. dollar."
Traders favored the safety of the greenback, having sold it before the Federal Reserve meeting earlier in the week as they hedged against a small possibility that the bank would take aggressive quantitative easing steps.
Instead, it announced the continuation of its "Operation Twist" which sells short-term bonds and buys longer-term securities, prompting traders to buy back the dollar.
The U.S. dollar and the Japanese yen are usually the most sought-after currencies during financial market stress and economic uncertainty.
Shift Away From Risk
Investors have been shifting away from riskier assets after China's factory sector shrank for an eighth straight month, business activity in the euro area contracted for a fifth month and U.S. manufacturing grew at its slowest pace in 11 months.
Added to that, Moody's on Thursday cut the credit ratings of 15 global banks including JPMorgan and Morgan Stanley.
Commodity currencies were hit hard as well, with the Australian dollar suffering its biggest one-day percentage fall in six months. The growth-linked Aussie [AUD=X 1.0036 -0.0015 (-0.15%) ] was nearly flat at $1.0056.
The dollar rose 0.2 percent against the yen [JPY= 80.39 0.18 (+0.22%) ] at 80.34 yen, having hit a five-week high of 80.525. The yen normally tends to gain in times of heightened uncertainty, but this time investors are fretting over Japan's economic problems.
Bickering in the ruling Democratic Party of Japan, which may lead to a snap election, will further undermine unpopular Japanese Prime Minister Yoshihiko Noda's ability to tackle the country's massive debt, twice the size of its $5 trillion economy.
"Short-term accounts and hedge funds sold off the yen as Japan's fiscal woes once again came into light, with the ruling party split over a vote on a sales tax hike," said a Tokyo based trader.
Market participants speculated that if the tax bill is passed, there would be even more pressure on the central bank to loosen its policy further.
