NEW YORK (Reuters) - The euro rose against the dollar for a second straight day on Tuesday as surprisingly strong German economic sentiment and optimism the United States will avoid a fiscal crisis had investors broadly embracing risk.
The start of a two-day Federal Reserve policy meeting weighed on the dollar as well due to expectations that the Fed will launch a new round of U.S. economic stimulus.
The euro, which has gained about 0.2 percent in December and is up around 1.2 percent so far in the fourth quarter, could rise further against the dollar if the Fed signals more bond buying.
The single currency has notched a mere 0.5 percent gain so far in 2012.
But the big driver of risk taking was Germany's ZEW economic sentiment index. Morale among German analysts and investors improved sharply in December, according to a monthly poll by the ZEW think-tank, fanning hopes that Germany, Europe's largest economy, will avoid recession this winter.
"The ZEW reading seemed to suggest that investors believed that Germany would be able to avoid a recession and begin to grow again as the year progressed," said Boris Schlossberg, managing director of FX strategy at BK Asset Management in New York. "The news helped to propel the euro/dollar to fresh session highs."
The euro last traded up 0.5 percent at $1.3004, not far from the New York session peak of $1.3014.
Ulrich Leuchtmann, head of FX research at Commerzbank in London, said the ZEW data would throw into question the European Central Bank's grim economic forecasts for the region and growing expectations of an interest rate cut early next year. The Bundesbank has also slashed its growth forecast for Germany in 2013 and warned that Germany could tip into recession.
On Monday, the euro had hit a two-week low against the dollar on rate-cut expectations, a gloomy economic outlook and political turmoil in Italy after Prime Minister Mario Monti said over the weekend that he would resign early. But it recouped lost ground after Monti said there was no danger of a vacuum before the elections.
Bets that the White House and Congress will reach a deficit reduction deal by the end of the year caused stocks to rally on Tuesday but weighed on the dollar. An agreement is needed to avoid massive tax increases and spending cuts beginning early next year that economists say could send the United States back into recession.
The dollar's status as a safe-haven currency means it would likely fare well if the United States fails to avoid the "fiscal cliff."
U.S. House of Representatives Speaker John Boehner, the top Republican, offered no concrete signs of progress on Tuesday on the fiscal cliff talks with the White House but said he remained hopeful that both sides would reach an agreement by the end-of-year deadline.
Investors were also reluctant to buy the dollar with the start of the Fed's policy meeting. The Fed is expected to replace its expiring "Operation Twist" program with another Treasury bond-buying plan when it issues its policy statement on Wednesday.
"The expected supplementation of quantitative easing in the expiration of Operation Twist is the main motivation of risk strength and could prove to lift the markets heading into the New Year particularly if the fiscal cliff is solved," said Neal Gilbert, market strategist at GFT Forex in Grand Rapids, Michigan.
Many economists believe the Fed will announce monthly bond purchases of $45 billion, although some think it could be more.
The expectations of more Fed easing pushed the Canadian dollar higher, with the U.S. dollar falling to a two-month low, while the New Zealand dollar hit a nine-month high. The New Zealand dollar also rose to a 2-1/2-year high against the yen.
Against the yen, the dollar was last up 0.2 percent at 82.42 yen, according to Reuters data, on growing expectations an election in Japan on Sunday could result in pressure for more stimulus from the Bank of Japan.
Dollar/yen price movement remains constricted given that the tight range from November 22 has narrowed further over the past four sessions, according Eric Theoret, currency strategist at Scotiabank in Toronto.
"Prior levels of support for dollar/yen that had been just below 81.80 have risen above 82, while resistance has remained solid above 82.80," he said.
"Any potential for yen strength in reaction to a dollar-negative Fed decision would be mitigated by near-term expectations of BoJ policy," he said.
Additional reporting by Nick Olivari; Editing by James Dalgleish