By Anirban Nag
LONDON, May 28 (Reuters) - The euro recovered from two-year lows on Monday as Greek opinion polls showed parties which favour sticking with the country's international bailout deal gaining support, leading investors to cut some of the record bearish bets against the common currency.
Most investors were pessimistic over how long the rebound would last, with many worrying about the lack of growth in Europe and the fragile health of Spanish banks. These concerns have dragged the euro 4.7 percent lower in May and left it on track for its worst monthly performance since September.
The euro drew support from opinion polls which suggested a victory for the conservative New Democracy party in the June 17 election. That would make it more likely that the next Greek government will stick to the terms of the bailout agreed with the European Union and the International Monetary Fund, enabling it to stay in the currency club.
These expectations saw the euro rise 0.7 percent to $1.2595 , pulling away from Friday's $1.2495, its lowest level since July 2010. It hit a session high of $1.2625 as stop-loss orders above 1.2620 were triggered, although robust offers layered at $1.2630/50 would check gains, traders said.
Volumes though were on the lower side due to a holiday in some parts of Europe, with the U.S. also shut.
"Investors have got a bit exhausted selling the euro in the absence of more negative news," said John Hardy, currency strategist at Saxo Bank. "So we are seeing some consolidation after the euro's sharp drop from $1.33 to around $1.25."
Indeed, speculators bolstered their euro bearish bets to record highs in the week ended May 22, while dollar longs rose to the highest since at least mid-2008, leaving ample scope for a correction as they cut positions and book profits.
"Heading into the Greek elections we'll fluctuate a lot. Because the market is very, very short euro, reactions to any positive news may be bigger than those to negative news," said Mitul Kotecha of Credit Agricole Corporate and Investment Bank.
"That said, even if we get some good news from Greece, the weight of bad news elsewhere is likely to keep any bounce in the euro short-lived," he said.
Sentiment towards the euro took a knock towards end of last week as the state takeover of Spain's fourth-largest lender, Bankia, intensified worries that the rising cost of supporting banks may push the euro zone's fourth-largest economy to seek an international bailout.
The bank last week asked for rescue funding of 19 billion euros and its shares opened down 26.75 percent on Monday. On top of that, Spain revealed that its highly indebted regions faced 36 billion euros of debt refinancing bills this year, way above the previously stated 8 billion euros.
All of which drove the yield spread between 10-year Spanish and German 10-government bonds to a euro-era high.
The euro also rose against the Swiss franc to 1.2030 after the Swiss National Bank head Thomas Jordan said that Switzerland is drawing up plans for emergency measures including capital controls in case the euro collapses.
He added he will continue to defend a cap on the franc in the meantime. The euro had jumped to its highest since mid-March on Thursday on rumours that Swiss authorities were planning to impose taxes on bank deposits.
With the euro gaining some ground, the dollar index, which tracks its performance against a basket of major currencies, came off its highest level since September 2010, hit on Friday, to last stand at 81.958, down 0.5 percent on the day.
The dollar also lost 0.3 percent against the yen, last fetching 79.40, with traders citing dollar-selling by Japanese exporters who had missed a chance to sell it above 80.00 yen and are now doing so at lower levels.
The yen was further supported as the Bank of Japan minutes suggested a pause in easing, by complaining of "misunderstanding" in markets that they will keep loosening automatically until 1 percent inflation was in sight.
The Australian and New Zealand dollars jumped more than 1 percent against the dollar. The Aussie was bolstered by buying from real money investors and corporates and that helped it pull away from a six-month low of $0.9690 hit last week.
(Additional reporting by Antoni Sladkowski; Editing by Catherine Evans)