The yen dropped to its lowest against the U.S. dollar in more than two years Thursday on expectations a new government in Tokyo will push for aggressive monetary stimulus to boost a sluggish economy and take steps to weaken the Japanese currency.
The dollar, meanwhile, got a bid against the euro, Australian, and New Zealand dollars on U.S. budget issues.
U.S. Senate Majority Leader Harry Reid said Thursday the United States looks headed to go over the "fiscal cliff" of tax hikes and spending cuts set to kick in next week. The greenback tends to benefit when there are snags in U.S. budget negotiations because it is highly liquid. Conversely, when talks are running smoothly, investors tend to take on more risk and buy currencies such as the euro and Australian dollar.
(Read More: Betting on Yen to Fall Further in 2013? Think Again)
But in a quiet week before the New Year holiday, the focus remained squarely on the yen. Speculators and hedge funds were increasingly looking to sell yen for dollars, traders said. Some said a dollar close above its 200-week moving average of 84.95 yen on Friday — the first since late December 2007 — would be a strong signal of further strength in the U.S. currency.
The dollar rose to 86.33 yen, its highest since mid-August 2010.
Investors took out option barriers at 86 yen and stop-loss buy orders above 86.10.
"Investors are looking to see whether the Bank of Japan will ease at its next policy meeting in January, and if it doesn't ease aggressively enough, then the new government could come, which would hurt the BoJ's independence," said Shaun Osborne, chief currency strategist at TD Securities in Toronto.
Prime Minister Shinzo Abe, who has threatened to revise a law guaranteeing the Bank of Japan's independence if it refuses to set a 2 percent inflation target, appointed a cabinet of close allies on Wednesday.
"There's limited scope for a yen rebound while the Abe government continues to threaten BoJ independence," Osborne said. The yen has fallen around 10.6 percent versus the dollar in 2012, its biggest annual drop since 2005, with most of that weakness coming in the past two months as expectations mounted Abe will pursue policies to weaken the yen.
A weaker yen helps Japanese exports and has already lifted Japanese stocks. Japan's benchmark Nikkei share average hit a 21-month high on Thursday and has climbed 22 percent this year, putting it on track for its best yearly gain since 2005.
(Read More: Why Falling Yen May Trigger Rise in Asian Stocks)
In the options market, risk reversals in dollar/yen showed a further bias toward yen weakness. Risk reversals from one-month up to four-years were skewed toward dollar calls or yen puts, reflecting increased confidence among investors to bet against the Japanese currency.
One-month implied dollar/yen volatility, a gauge of expected moves, rose to 8.5 vols from 7.3 last week, close to the Dec. 13 near-six-month high of around 8.65, highlighting growing demand to hedge against sharp price swings.
The yen touched its lowest level against the euro since early July. The euro hit 114.31 yen, a 17-month high.
Edge of the 'Cliff'
The euro traded at $1.3235, nearly flat for the day and below an eight-month high of $1.3308 hit last week. Europe's common currency had traded higher for most of the session. Reid's comments on the fiscal cliff pressured the euro, analysts said.
TD Securities' Osborne said a week ago that it looked like going over the cliff was a 50-50 proposition. "But now it seemed like a certainty, with everyone giving up on the negotiations," he said. "So now it looks like we slide off the cliff in the new year, and then we have to take it from there."
Should Congress fail to act by Dec. 31, tax rates for all Americans would jump back to pre-2001 levels. Two days later, $109 billion in automatic spending cuts would start to take effect.
Together, the higher taxes and lower spending would suck about $600 billion out of the U.S. economy, potentially causing a new recession in 2013. The dollar index stood at 79.68, up 0.1 percent for the day and above a two-month low of 79.008 hit last week.