The euro fell against the dollar on Monday, pulling back from a two-month high, with investors betting recent gains were too far, too fast as upcoming results of stress tests on European banks loom.

Some in the market said the euro had been knocked by a weekend German magazine report that the stress tests would include loan markdowns on German sovereign debt under certain conditions, countering reports last week that the tests would exempt German haircuts.

The single currency was also under selling pressure after its failure late last week to rise above a downtrend line drawn through the euro's high hit in December and an April peak, and resistance was seen just above $1.2700.

After enjoying a sizable run-up in recent weeks, the single currency appeared overbought at last week's levels, said Omer Esiner, chief market analyst at Commonwealth Foreign Exchange, Inc.

The latest figures on IMM speculative positions showed a sharp decrease in bets against the euro, consistent with its recent rally. But some analysts say the current level of bets may open the door for investors to start once again rebuilding euro short positions.

With euro shorts now cut so sharply, the scope for clients to enter new short positions has increased substantially, leaving the euro especially vulnerable to a possible shift in sentiment, said Gareth Berry, a currency strategist at UBS AG.

In late morning trading in New York, the euro EUR= was down 0.5 percent on the day to $1.2563, after hitting $1.2723 on Friday. Traders reported Asian demand around the day's lows at $1.2550 with stops lurking below, ahead of stronger bids placed on the approach to $1.2500.

Markets were looking ahead to second-quarter earnings results from U.S. firms, with Alcoa Inc. reporting on Monday. A recent string of weak U.S. economic data has raised speculation the recovery may be losing momentum and has hurt the dollar.

Also ahead are more details of stress tests on 91 European banks -- the results of which are due on July 23 -- as the European Union seeks to restore confidence in the sector.

In the near term, the euro could suffer from any disappointment triggered by the stress tests, said Berry.

The yen pared losses against the dollar in volatile trading following Japanese election results showing political uncertainty ahead.

The dollar index .DXY, which tracks the dollar versus a basket of other currencies, rose 0.4 percent, recovering from a slide to 83.622 on Friday, its weakest since May 10.

Brad Bechtel, a managing director at Faros Trading LLC, said investors should keep an eye on the 85.00 level in the dollar index. This needs to hold for the recent dollar bears to maintain their momentum, he said.

JAPAN ELECTIONS

Against the yen, the dollar fell slightly, trading 0.1 percent lower at 88.43 yen JPY=, having climbed as high as around 89.15 yen.

The yen initially suffered after Japan's ruling coalition, led by Prime Minister Naoto Kan's Democratic Party of Japan (DPJ), lost its upper house majority in an election on Sunday, putting at risk efforts to deal with the country's debt.

Tokyo traders said the election outcome triggered unwinding in long yen positions, which rose significantly last week.

It is difficult to prognosticate if the latest political developments in Japan will have long-term consequences on dollar/yen, said Boris Schlossberg, a director for currency research at GFT Forex. The pair tends to trade on interest rate differentials.

Schlossberg added that if U.S. company earnings this week support the view interest rates are likely to rebound off their recent lows, dollar/yen should in turn move higher irrespective of the political uncertainty surrounding Kan and the DPJ.

U.S. earnings, in addition to data on inflation, retail sales and manufacturing, will be the highlight of the week given growing speculation the U.S. economy may be stumbling.

Japan European union