The euro weakened across the board on Tuesday after a German constitutional court ruled that the Bundesbank must stop buying government bonds if the European Central Bank cannot prove those purchases are needed.
The decision did not apply to the ECB's latest pandemic-fighting programme, a 750 billion euro scheme to prop up the economy, but the ruling unsettled financial markets, which had been calmed by aggressive ECB asset purchases to prevent the coronavirus crisis leading to an economic meltdown.
The single currency fell 0.7% to $1.0826 in the wake of the ruling and is on track for its biggest single-day drop since the beginning of April, Refintiv data showed.
"Markets don't seem to like anything that the ECB can't fix, but as things stand at the moment, this is a pretty big bump in the road," said Andrea Cicione, head of strategy at TS Lombard in London.
"People like us are going through the decision, trying to understand what it means for possible countermoves by the ECB and while this takes place, markets do not like uncertainty and that's why they're reacting negatively."
Also hurting the euro was the presence of a large long position in the single currency which has intensified the selling pressure.
Latest positioning data showed bullish euro bets were at their biggest level in nearly two years. But the euro currency has weakened by more than 5% from more than one-year highs of nearly $1.15 hit in March.
Nomura strategists recommend a short position in euro/dollar expecting the single currency to weaken to $1.06 over the coming months.
The euro's drop pushed the dollar higher for a second consecutive day with the dollar index rising 0.4% to 99.91.
"It illustrates the difficulties versus the Fed for example; the Fed has no such constraints of US states challenging QE (quantitative easing) there," Societe Generale strategist Kenneth Broux said.
The dollar's gains were also supported after US President Donald Trump stepped up verbal attacks on China, raising fears of a new trade war.
The Australian dollar edged up more than 64 cents to $0.6454 after the Reserve Bank of Australia left its targets for the cash rate and three-year government bond yields unchanged at 0.25%. But the bank forecast the Australian economy would suffer its largest ever contraction in the first half of the year.
Other commodity currencies like the Norwegian crown also advanced as oil prices bounced. Trading was light because of public holidays in Japan and China. The yuan rose to 7.1195 per dollar in offshore trade, recovering from a six-week low of 7.1560 hit in the previous session, but well below the range it was in last month.
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