LONDON -- The dollar weakened on Tuesday, particularly against a buoyant euro, on persistent speculation the Federal Reserve could soon take additional measures to ease tightening U.S. credit and liquidity conditions.
In see-saw trade, the yen surrendered earlier gains after the People's Bank of China raised interest rates, with some traders saying it showed the Chinese economy continues to boom and therefore tempted some investors back into riskier carry trades.
But overall, the speculation about a Fed move on rates sooner rather than later — either another discount rate cut or even a lowering of the federal funds target rate — weighed heaviest on currency market sentiment.
European stocks pared earlier losses, short-dated government bond yields remained under pressure and credit spreads narrowed, ahead of a closed-door meeting at 1400 GMT between Fed Chairman Ben Bernanke, Treasury Secretary Henry Paulson and Senate Banking Committee Chairman Chris Dodd on the state of financial markets.
"You've got to think that if they do cut (rates) there is no other position to have except short dollars ... if the rumours are true of a potential Fed cut," said a dealer in London.
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At 1155 GMT the euro was up 0.3 percent on the day at $1.3510, and was up 0.1 percent against the yen at 154.90 yen, having traded as low as 153.55 yen in early London trade.
The dollar was down 0.3 percent against the yen at 114.60 yen, trimming earlier losses, but was down around 0.15 percent on an index basis against a basket of major currencies at 81.30.
U.S. RATES KEY
The high-yielding New Zealand dollar totally reversed course, clawing back earlier losses of 1 percent against the yen to trade flat on the day at 80.23 yen and up on the day against the greenback at $0.70.
The New Zealand dollar is often seen as a good proxy for carry trade appetite, where low-yielding currencies are sold for higher-returning asssets.
Sterling bounced around a cent from its intraday low to trade only 0.1 percent down on the day at $1.9850.
The yen's rebound came after the PBoC said it raised interest rates for the fourth time this year, effective Wednesday. For more, click on link.
Last Friday the Fed cut the discount rate it charges on direct loans to banks by half a percentage point to 5.75 percent, saying credit market tightening could slow U.S. growth.
That fuelled expectations that the U.S. central bank could lower the federal funds rate from the current 5.25 percent, given the threat to the economy from evaporating credit.
The market will also look to comments by Richmond Fed President Jeffrey Lacker in a speech on the economic outlook at 1630 GMT.
Earlier on Tuesday, the carry trade unwind had been the dominating trend.
The chief executive of German state-backed bank WestLB said the country's banking sector was in a "not uncritical situation" and the Bank of England said it had lent 314 million pounds to an unidentified borrower or borrowers on Monday via its standing facility.
While not in itself a major surprise, the news did little to soothe worries that the credit distress swirling through markets shows no sign of dissipating.
"Our risk indictor ... confirms that a major shift in medium-term market sentiment is taking place, suggesting that the impact from the current credit crisis is likely to be more significant and prolonged than the market was initially assuming," said Ian Stannard at BNP Paribas in London.
Also on Tuesday, the European Central Bank held its weekly tender, allotting 275 billion euros in 7-day refinancing to the region's banks. See.
Data also showed Germany's ZEW investor sentiment index falling much more than expected in August, and June's euro zone trade surplus widened.
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