The dollar hit a three-week low against a basket of currencies and dropped sharply against the euro on Thursday, as investors shone a spotlight on US financial sector health and jammed-up money markets. Underscoring the seriousness of the situation in bank-to-bank lending, major central banks moved in coordinated fashion to inject dollar liquidity.
Anxiety about the banking sector deepened this week after the collapse of Lehman Brothers, while the bailout of US insurer AIG failed to stem a crisis of confidence as financial institutions ran scared of lending to one another.
"There's general nervousness on the US financial sector as investors have become very much more concerned on the US-centric leg of the downturn. It's tough to stand in the way of a dollar retracement until some degree of stability emerges," Rabobank markets strategist Jeremy Stretch said.
The US Federal Reserve and the world's top central banks offered to pump billions of dollars into global money markets to ease funding pressure. "Risk aversion has been increasing and riskier currencies have tended to fall, but that trade seems to be softening a little now (after the central bank moves)," Westpac economist James Shugg said.
The central bank action helped ease deadlock at the short end of interbank lending markets, with the London interbank offered rate (Libor) for overnight US dollars sliding sharply to 3.84375 percent on Thursday from 5.03125 percent on Wednesday. That's still almost 2 full percentage points above the Fed's 2 percent target rate.
At 1125 GMT, the dollar index, which tracks the currency's performance against six major currencies, was down 0.9 percent at 77.512, having earlier hit a three week low at 77.260. The euro jumped 1.25 percent to $1.4478 and 1.4 percent against the yen to 151.50 yen. The dollar was up 0.25 percent at 104.40 yen.
High-yielding currencies such as the Australian and New Zealand dollars also benefited, with the Aussie dollar climbing 2.5 percent to US $0.8059. Sterling added 0.6 percent to $1.8256, firming after British bank Lloyds TSB sealed a 12.2 billion pound ($21.7 billion) deal to buy HBOS Plc and following data showing an unexpected 1.2 percent jump in British retail sales in August.
But fear about what the next item of bad news will be and uncertainty about how to interpret recent developments continue to dominate trading. "No one is taking more than a 10 minute view on anything at the moment, and liquidity is as bad as I've ever seen it," a trader said.