The dollar rose for a third straight session against major counterparts on Tuesday as traders bought back the currency on the view markets have already priced in expectations the Federal Reserve will maintain its bond-buying program in coming months.
Traders also said the dollar's recent drop, which had taken it to a nine-month low against a basket of currencies, may have been overdone. But sentiment remains negative and investors will likely see any rebound as a selling opportunity.
The Fed is unlikely to shift monetary policy at the end of its two-day meeting on Wednesday as it awaits more evidence of how badly Washington's budget battle has hurt the economy. Most expect the Fed will not begin reducing its $85 billion per month bond-buying program until March 2014.
"With that largely priced in, there's a risk that they mention maybe that it's not going to be quite as long of a delay as what the markets anticipated," said Eric Viloria, currency strategist at Forex.com in New York. "I would say that the rebound we're seeing today is probably just some short-covering ahead of the statement tomorrow."
The dollar index, which tracks the greenback against six currencies, rose 0.5 percent to 79.631, moving further away from a nine-month low of 78.998 set on Friday. Should the Fed sound less dovish or provide a hint as to when it may curb its asset purchases, the dollar could gain as participants cover bets against the currency.
Currency speculators went short, or bet against the dollar, in the week ended October 8 for the first time since mid-February, according to data from the Commodity Futures Trading Commission released on Monday and Reuters calculation. Alvin Tan, currency strategist at Societe Generale, said light trading volumes, which were at least 20 to 30 percent lower than usual, also helped amplify movements.
The euro fell 0.3 percent to $1.3741. It had earlier risen to a session high of $1.3813, not far from last week's two-year peak of $1.3832, after European Central Bank Governing Council member Ewald Nowotny told MNI that he saw no tool the central bank could use against a strong euro. The single currency has climbed about 8 percent against the dollar since early July.
Some traders said the euro could struggle to gain further, with investors remaining wary the ECB may express discomfort with the single currency's strength in the coming weeks. "One gets the feeling speaking to clients that moves in the euro and expectations that the Fed will be dovish have gone too far," said Manuel Oliveri, FX strategist at Credit Agricole. "To that extent, we think the dollar's downside is limited." Against the yen, the dollar rose 0.5 percent to 98.14 yen , while the euro gained 0.2 percent to 134.87 yen .
Earlier, US data showed US consumer spending rose in September, but consumer confidence tumbled in October as a partial government shutdown rattled households. With lawmakers yet to agree on a budget, economists fear another damaging fight might be in the cards early next year, which could further hit confidence in the US currency. The Australian dollar retreated after Australia's top central banker said it was likely the currency would fall materially given the country's declining terms of trade. It last traded 1 percent lower at $0.9477, down from last Wednesday's $0.9758, a more than four-month high, according to Reuters data.