(Reuters) - The euro eased against the dollar on Friday as some investors took profits on Thursday's rally to a seven-week high, although lingering optimism that policymakers are edging closer to tackling the debt crisis are likely to check losses.
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 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 September 6. It was last trading at $1.2525, down 0.3 percent and below Thursday's peak of $1.2590, its highest since early July.
"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 an European central bank that has been actively diversifying its euro holdings into other currencies.
Investors awaited a meeting between Greek Prime Minister Antonis Samaras and German Chancellor Angela Merkel on Friday, although any flexibility on Greek austerity measures is unlikely to be discussed before at least September.
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 September6, there are Dutch elections and a German Constitutional Court ruling on the euro zone rescue fund on September 12 and an EU finance ministers' meeting starting on September 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.
FED POLICY EYED
The dollar came under pressure this week after Fed minutes suggested the U.S. central bank may opt for more monetary stimulus "fairly soon".
The U.S. monetary policy will be in focus at the annual conference of central bankers and economists at Jackson Hole, Wyoming on August 31, where Federal Reserve Chairman Ben Bernanke will give a speech.
However, St. Louis Federal Reserve President James Bullard, who does not vote on the Fed's policy committee, said the minutes were a bit stale given stronger data since the Fed's last policy meeting.
The dollar was flat at 78.50 yen while against a basket of the currencies, the dollar index .DXY climbed 0.2 percent to 81.531. It fell to a two-month low of 81.221 on Thursday.
The Australian dollar fell to a four-week low against the U.S. dollar of US$1.0378, hurt by concerns over slowing growth in China and continuing debate whether the country's mining boom was coming to an end.
Sterling dropped to $1.5821 from $1.5845 after an upward revision of UK gross domestic product was in line with expectations, wrongfooting some who expected a shallower recession.
