(Reuters) - The euro recovered from steep falls against the dollar on Thursday as market participants took profit on short positions, but more weakness was expected as investors fretted the euro zone crisis was spreading to Germany.
The single currency slid to a seven-week low of $1.3320 on Wednesday as a weak German government bond auction sparked fears that even the safe-haven status of Europe's biggest economy could be under threat.
Short-covering helped the euro recover to trade up 0.25 percent at $1.3370 and analysts said it could edge higher short-term, particularly given that trade is thin due to the U.S. Thanksgiving holiday.
However, the extent of bearish sentiment toward the single currency left it on track to retest the October low of $1.3144, having retraced more than 78.6 percent of the rally from that level to the late October high of $1.4247.
"Short-covering may continue for a bit and we look for a correction perhaps to $1.3430 but thereafter it is heading south. It is a case of two steps down and one step up for the euro," said Carl Hammer, currency strategist at SEB in Stockholm.
The euro was also helped by a better-than-expected German business climate survey on Thursday, though traders said the data was unlikely to temper fears about the possibility the euro zone economy could face recession.
It rose briefly above $1.3400 but traders said this only provided better levels to sell the currency and reported offers between $1.3415 and $1.3450 that were likely to cap any rise.
The market looked to a meeting of leaders of Germany, France and Italy on Thursday, although few players expected progress in steps to deal with the crisis.
"With any rally in the euro there will be a lot of investors looking for new opportunities to set new short positions," said Niels Christensen, currency strategist at Nordea in Copenhagen.
"Going forward there will be a lot of focus on bond auctions and no one would be surprised if investors were reluctant to buy aggressively."
Germany's bond sale on Wednesday was its least successful since the launch of the single currency. Although unattractively low yields played a part, investors worried about the rising cost of bailouts as more euro zone countries come under attack.
German Bund futures fell to their lowest level in nearly a month, though Italian, Spanish and French bonds benefited from a slight rebound in riskier assets as European shares finance/markets/index?symbol=gb%21FTPP">.FTEU3 gained more than 1 percent. <GVD/EUR>
The euro was at 103.09 yen, having earlier hit a seven-week low of 102.92 yen, opening the way for a test of the decade low of 100.77 yen hit in early October.
Investors have also been unnerved by a rise in Belgian bond yields as the country -- without a formal government since elections last June -- struggles to agree on a deficit-slashing budget for next year.
The euro's recovery helped other riskier currencies, with the Australian dollar up 0.6 percent at $0.9744, having slid to a seven-week low of $0.9664 on Wednesday on concerns about a deteriorating global growth outlook.
The dollar slipped 0.25 percent against the yen to 77.09 yen, with its rise to a near two-week high on Wednesday, when Tokyo was on holiday, luring Japanese exporters to sell.