The yen held firm near recent peaks versus the euro and dollar on Wednesday, as investors paused for reflection after a week of unwinding carry trades sparked by a rise in risk aversion and tumbling equity markets.
Investors have curbed their exposure to risk on concern about the health of the US economy - specifically its subprime mortgage market, which deals in loans to people with weak credit - plus geopolitical jitters and a sharp sell-off in Chinese equities at the start of last week.
In foreign exchange, this has led to an unwinding of carry trades in which people borrow low-yielding currencies such as the yen or Swiss franc to fund purchases of higher-return assets. The potential risk is that returns are wiped out by the appreciation of the funding currency, and thus investors are unwilling to hold such trades in times of high volatility.
But after days of sharp rises in the yen - and a brief correction lower on Tuesday - a precarious calm has descended as share markets stabilise, leaving investors to figure out whether further volatility is likely.
Analysts were split on whether the recent moves were the start of a deeper carry trade unwind or whether, with Japanese and Swiss rates seen rising only gradually, investors will return to carry once market volatility eases.
"We think that this is a financial correction rather than a fundamental one, hence we are inclined to treat this as a temporary hiatus in the search for yield and the performance of carry trades," Teis Knuthsen, head of FX and Fixed Income Research at Danske Markets, said.
"However there is a risk that the financial correction will become a fundamental one if risk is being reduced in all markets including currency markets. If that's the case then this can go on for much longer." By 1256 GMT, the dollar was down 0.1 percent at 116.29 yen, in sight of this week's three-month low of 115.16 yen.
The euro eased slightly to 152.73 yen after posting its biggest weekly loss in 2-1/2 years last week followed by a bounce back of 1 percent on Tuesday. European equity markets were on firm ground on Wednesday, while Japanese stocks booked a modest loss. The euro was also flat at $1.3121 before a widely expected European Central Bank rate rise to 3.75 percent on Thursday. The focus will be on the post-decision news conference for clues on how soon rates may move to 4 percent.
The Bank of England's interest rate decision is also due on Thursday, with most economists polled by Reuters expecting UK rates to stay on hold at 5.25 percent.
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