NEW YORK (Reuters) - The euro advanced to a 16-month high against the yen and an 8-1/2-month peak versus the dollar on Wednesday, bolstered by better-than-expected German business confidence data and increasing optimism about debt-plagued Greece.
The yen also weakened to its lowest in more than a year and a half against the dollar on expectations the Bank of Japan will ease monetary policy at the end of a two-day meeting Thursday.
Many analysts said the euro could extend gains against both the dollar and yen thanks to year-end demand from corporate and long-term investors in thin trading conditions. Currency speculators are also cutting short euro positions built earlier this year as worries about the euro zone have eased.
On Wednesday, Germany's Ifo survey showed business sentiment rose for a second straight month in December, raising hopes Europe's largest economy will get back on track after stumbling a little bit the last few months. The expectations component of the Ifo survey also increased.
"The euro is doing well across the board and there are fundamental drivers here," said Vassili Serebriakov, currency strategist at BNP Paribas in New York.
"We had good data from Germany, plus we're getting the sense that there is a smooth resolution of the Greek problem."
The euro rose 0.36 percent to 111.79 yen, hitting 112.49, its highest since August 2011. Investors took out a reported options barrier at 112 yen.
Against the dollar, the single euro zone currency rose to $1.3308, its strongest level since early April. By mid-afternoon New York trade, the euro gave up some of those gains to trade at $1.3242, a gain of 0.11 percent on the day.
On Tuesday, ratings agency Standard & Poor's raised Greece's credit rating after the country completed its bond buyback program. S&P gave Greece a stable outlook given the euro zone countries' commitment to support Greece's membership in the European bloc. That helped the euro trade on a firmer note overnight.
Traders also said a year-end squeeze of short positions has further underpinned the euro, although the jury is out on how much further the single euro zone currency can profit from this.
Greg Anderson, senior currency strategist at CitiFX in New York, thinks the pressure on euro short bets is likely to end by the U.S. close on Friday, when much of the market will go on holiday. No one really wants to hold long euros in an illiquid Christmas week, he explained.
"I suspect that the euro could get to $1.35 if the U.S. miraculously reached an agreement on a 'grand bargain' solution to the fiscal cliff. Absent that, I doubt that the euro rally would extend more than 1-2 percent further on any cross," said Anderson.
U.S. President Barack Obama on Wednesday threatened to veto a Republican tax plan, known as "Plan B", because it does not do enough to raise taxes on the wealthy or address spending cuts needed to tame the country's $16 trillion in debt. Talks to avert the fiscal cliff have turned sour even after recent progress.
The euro came off its highs against the greenback after the White House made known its displeasure with the opposition Republican plan, undermining tepid progress on the budget talks.
If U.S. policymakers do reach a compromise to avert steep tax increases and spending cuts early next year, currencies that tend to gain on a better global growth outlook - like the euro and Australian dollar - should benefit at the expense of the safe-haven dollar.
The dollar index <.DXY> fell to a two-month low of 79.008 before ricocheting higher to trade at 79.273, off 0.1 percent.
BROAD YEN WEAKNESS
The dollar, however, rose against the yen to a 20-month high of 84.61 yen as it broke through an option barrier at 84.50. It triggered stop-loss buy orders above that level.
The dollar last changed hands at 84.37 yen, up 0.2 percent.
Traders reported steady buying of short-dated topside strikes in the dollar/yen options, reflecting the likelihood of more weakness in the yen.
Expectations of looser policy from the BoJ, which tend to weigh on the yen, have been bolstered by a landslide election victory for Japan's Liberal Democratic Party at the weekend. The LDP is committed to aggressive monetary easing.
The BoJ concludes a two-day policy meeting on Thursday and is widely expected to announce another round of monetary easing.
Fourteen of 19 economists polled by Reuters last week said they expected the BoJ to ease this week, most likely by increasing its 91 trillion yen ($1 trillion) asset-buying and lending program by up to 10 trillion yen.
Some analysts, however, warned that BoJ measures could fall short of expectations, leading some to buy back the yen.
(Additional reporting by Daniel Bases in New York and Nia Williams in London; Editing by Nick Zieminski)
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