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The yen fell to record lows versus the euro and multi-year lows against high-yielding currencies on Tuesday as investors continued to shun the Japanese unit in favour of higher-yielding currencies.
With the focus on interest rate differentials, the euro ticked up to a two-week high versus the dollar, boosted by expectations that the European Central Bank will raise rates to 4 percent on Wednesday and signal further monetary tightening.
That would further narrow the yield gap with the United States, where the Federal Reserve is eventually seen cutting rates from the current 5.25 percent, although recent strong US data means the cut may come later than previously thought.
A growing conviction that the world's largest economy will avoid a hard landing has also boosted investors' risk appetite, fuelling carry trade investments funded by borrowing the low-yielding yen.
"The market seems to be quite comfortable with continued higher risk appetite and continued carry trades. It seems the problems on the Chinese stock market are not something spreading outside of China at the moment," SEB currency strategist Johan Javeus said.
By 1140 GMT, the euro was up almost 0.1 percent on the day at $1.3513, pulling away from a near two-month low of $1.3391 hit last week. Data showing euro area service sector growth rising at a marginally faster rate than expected in May backed a robust view of ECB monetary policy.
The single currency scored a record high versus the yen for a second session in a row at 164.61 yen. The dollar was steady at 121.72, stopping short of a four month high of 122.14 yen touched late last week.
The yen fell to 15-year lows against sterling and the Australian dollar and 17-year lows versus the New Zealand dollar, which enjoys the highest interest rates in the industrialised world at 7.75 percent. The kiwi also hit a 22-year post-float high versus the US dollar.
One-month implied volatility in euro/dollar fell to record lows, while Chinese stock markets recovered from earlier steep losses and European bourses opened higher - all factors supportive of risk appetite. Bank of Japan Governor Toshihiko Fukui said on Tuesday that the BoJ needs to watch for risk of a sharp unwinding of carry trades.
But analysts say the yen will be in for more losses against higher-yielding currencies even though the BOJ is seen lifting rates as early as in August, given that rates in those countries are also expected to rise in the near future. "The risk environment...has generally been benign. That sort of environment on the equities front has continued to mean that the higher yielding currencies have outperformed," Lehman Brothers G10 currency strategist Phyllis Papadavid said.

Copyright Reuters, 2007

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