The euro touched a four-month high against the dollar, getting an added lift after Spanish Prime Minister Mariano Rajoy was quoted by Finnish newspapers as saying Spain is considering asking for help from the European Central Bank's bond-buying programme.
The dollar index, which measures the dollar's value against a basket of currencies, fell to as low as 79.751, its lowest level since early May, and last stood at 79.805.
The dollar extended its losses in the wake of a warning from Moody's on Tuesday that the United States could lose its triple-A debt rating if next year's government budget talks do not produce policies that gradually cut the country's debt.
"Although everyone has been aware of the potential risks in the US fiscal situation, a warning at this time was a bit of surprise and triggered fresh selling," said Teppei Ino, currency analyst at the Bank of Tokyo-Mitsubishi UFJ.
John Boehner, the top Republican in the US Congress, said he had no confidence a divided Washington could avoid a "fiscal cliff" that threatens to push the nation into a recession.
Expectations that the Fed may embark on further stimulus measures at its policy meeting ending on Thursday are likely to keep the dollar under pressure for now.
"I feel that the market is getting a bit too excited about the chance of QE. Still those who have bought the dollar and sold the euro are now getting nervous ahead of the Fed meeting and being forced to cut their positions," said Katsunori Kitakura, associate general manager of market making at Sumitomo Mitsui Trust Bank.
The euro hit a four-month high of $1.2883 on trading platform EBS at one point, and last stood at $1.2873, up 0.2 percent from late US trade on Tuesday.
Traders said the euro might gain further if Germany's Constitutional Court approves the country's participation in the euro zone's bailout fund. The ruling is due at 0800 GMT.
"In the end, what it boils down to is that we're in the midst of a dollar-selling trend," said a trader for a European bank in Tokyo, adding that selling the euro may not work too well, at least over the next couple of days.
YEN NEAR DANGER ZONE?
The dollar index is testing an important support at 79.75, which is the 38.2 percent retracement of the rise from its 2011 low to two-year high hit in July. A break of that support would strengthen the case that its long-term uptrend since last year is over.
But the index might stage a rebound given some technical signals that it is oversold. Its 14-day relative strength index has fallen below 30, which suggests there is considerable chance of a corrective rebound in the near future.
Although chances are slim that Germany's top court will signal that Germany must change its constitution or hold a referendum before it can take part in any further integration of the European Union, such a ruling would drive the dollar higher.
Another potential source of disruption for the euro is a general election in the Netherlands on Thursday, though latest polls indicate radical anti-euro parties have lost the momentum they had just a month ago.
But given that two mainstream parties are too small to win outright majority, coalition talk is likely to take some time, making the election less likely to be a market moving event, said Junya Tanase, chief FX strategist at JPMorgan, noting it took four months to form a government last time.
The Japanese yen held near 3-1/2 month high against a broadly weak US dollar, trading at 77.89 yen per dollar , near Tuesday's high of 77.70 per dollar.
"We think the Fed will announce QE3 this week and that the dollar will continue to fall after the Fed meeting, possibly to around 77 yen within a few weeks," said JPMorgan's Tanase.
Curbing the yen's gains are expectations that, should the Fed announce large scale monetary easing, the Bank of Japan is also likely to take additional easing measures next week, market players said.