The dollar declined against the euro on Wednesday amid speculation the European Central Bank could signal at a meeting on Thursday that it intends to tighten monetary policy after 2-1/2 years of steady interest rates.
A day after the Federal Reserve raised rates for the 12th consecutive time to 4 percent and gave no indication of pausing its inflation-curbing campaign, investors have begun to consider other currencies in which interest rates could be headed higher.
"There has been a clear shift in ECB rhetoric and gears are shifting in favour of tighter policy," said Todd Elmer, currency strategist with Citigroup.
By late afternoon, the euro rose 0.5 percent against the dollar from late Tuesday to $1.2067. Against the yen, the euro hit a 2005 high above 141 yen, up around 0.6 percent.
In the past several weeks hawkish comments from ECB officials in the face of sluggish economic growth have caused the market to price in more than a 50 percent chance that the euro zone central bank will raise rates in December from their current 2 percent.
Higher interest rates could increase the attraction of euro zone assets in the near term. They may also spur some investors to unwind carry trades in which low yielding currencies are borrowed to invest in higher yielding ones.
"I think a lot of people are getting out of short euro positions against high yielders like the Aussie and Canada," said Rafael Martorell, chief dealer at BNP Paribas in New York.
Short positions are effectively bets a currency will decline.
Earlier during the European session, Swiss National Bank Chairman Jean-Pierre Roth said current rates were not appropriate for an economy that was recovering, an indication the central bank is close to raising rates.
As a result, the dollar fell 0.7 percent against the Swiss franc to 1.2785 francs. Sterling climbed 0.6 percent in sympathy to $1.7760.
Some analysts believe that the market has become too aggressive in pricing in rate hikes by the ECB especially since economic data from the euro zone have been mediocre.
Hawkish rhetoric from ECB officials may be more about cooling inflation expectations rather than signalling an imminent change in policy, said Citigroup's Elmer.
To Elmer, the dollar is still a more attractive investment.
"We continue to see more upside in terms of US rates as the Fed may not stop until 5 percent. So on a one-month horizon, there's still a strong story for dollar strengthening," he said.
The dollar earlier rose to fresh 25-month highs against the yen just below 117 yen, following Tuesday's interest rate hike by the Federal Reserve which further boosted the attractiveness of some dollar-denominated assets.
The dollar traded back down to 116.80, still up 0.1 percent on the day, after failing to pierce options-related defence of the 117 yen level.
Analysts say the yen, with its low yield, has been one of the biggest victims of the market's intense focus on interest rate differentials.
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