* Greek debt talks could yield breakthrough
* Net (Frankfurt: A0Z22E - news) euro short positions hit fifth straight weekly high
* Fitch downgrades five euro zone sovereigns
* USD/JPY drops on month-end exporter selling
NEW YORK (Frankfurt: A0DKRK - news) , Jan 27 (Reuters) - The euro rose to a 6-1/2-week high against the dollar on Friday as optimism that Greece will avoid a messy default had investors scrambling to cover short positions, but the currencies' upside could be contained if conditions in the region remain weak.
Data indicating a bumpy road ahead for the U.S. economy and a downgrade of five euro zone sovereigns by Fitch Ratings agency kept trading extremely choppy.
European officials voiced optimism that Greece could reach a deal with creditors to avoid a disorderly default.
Greece plans to submit a final offer on a bond swap to its private creditors by Feb. 15, Finance Minister Evangelos Venizelos said on Friday. Negotiations on a debt swap deal made progress and will continue over the weekend.
"Important for the euro will be if we continue to see an improvement in financing conditions in Europe (Chicago Options: ^REURUSD - news) ," said Charles St. Arnaud, foreign exchange strategist at Nomura Securities in New York.
"Over the past weeks, we have seen tensions in the funding market with lower Euribor-OIS spread, EUR basis swap, short-term yield on government bonds and good auction results," he said. "If we see a continuation of these trends, risk should continue to trade relatively well, pushing AUD/USD and NZD/USD higher and USD/CAD (Milan: CAD.MI - news) lower."
The euro hit its highest level since Dec. 13, rising to $1.3228 before retreating a bit to last trade at $1.3224, up 0.9 percent on the day, according to Reuters data.
Currency speculators increased their bets in favor of the U.S. dollar and raised their net euro short positions to a fifth straight record high in the latest week amid lingering doubts about the euro zone's debt crisis, according to data from the Commodity Futures Trading Commission released on Friday.
The euro briefly pared gains after Fitch Ratings downgraded the sovereign credit ratings for Belgium, Cyprus, Italy, Slovenia and Spain, indicating there is a 1-in-2 chance of further downgrades in the next two years.
Against the Swiss franc, the greenback seesawed after the GDP data. In late afternoon trading, the U.S. dollar was down 0.8 percent at 0.9124 franc.
Against the yen, the euro fell 0.1 percent to 101.34 yen as the Japanese currency recovered broadly from lows struck this week.
The yen's strength was based on "normal ... end-of-month buying of the yen by Japanese exporters," according to a commentary published by trader Dennis Gartman.
"They are usually 'in' at the month's end for this purpose, and they were a bit more aggressive than usual, given the yen's recent weakness," he added.
U.S. data on gross domestic product showed the economy grew at its fastest pace in 1-1/2 years in the fourth quarter, but inventory rebuilding by businesses and slower business spending warned of weaker growth in early 2012.
DELUGE OF DATA AHEAD
While investors will certainly keep a watchful eye on developments in Greece and yields on sovereign debt, currency prices will also take a cue from a deluge of European and U.S. economic data next week, ranging from European PMIs to U.S. home prices and Friday's U.S. Labor Department report on nonfarm payrolls and unemployment.
If U.S. data comes in softer than expected it may heighten expectations of a third round of quantitative easing from the Federal Reserve. That would weigh negatively on the dollar as QE3 would be tantamount to printing money and therefore dilute its value.
Fed Chairman Ben Bernanke this week painted a picture of an economy mired in slow growth, and the Fed delayed the timing for an interest rate hike until at least late 2014. He also suggested the U.S. central bank is open to buying more bonds in a bid to stimulate borrowing and investments.
The dollar last traded at 76.72 yen, 0.9 percent lower , leaving the yen on track for its biggest daily gain since late August.
"The yen is overvalued and its trade dynamics are reflective of the need to import energy, the softening of global demand and the overseas shift of production that was threatened by Japanese multinationals last year," said Constantine Ponticos, managing director, research, at Pareto Investment Management in London.
Ponticos said they have been recently been selling European currencies against everything, namely the U.S. dollar, Australian dollar and yen.
Pareto (Other OTC: PETOF.PK - news) , Bank of New York Mellon's currency specialist division, has $45 billion is the assets under management.
"In the absence of banking/sovereign crises elsewhere I would have expected the Japanese yen to be trading a lot lower but, in my opinion, the current account will not bring that about on its own in the near term," he said. (Additional reporting by Luciana Lopez and Nick Olivari in New York and Anirban Nag in London; Editing by Chizu Nomiyama and Dan Grebler)
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