The dollar and euro plunged against the yen Tuesday as investors booked profits in the aftermath of swift and significant gains, but looser Bank of Japan monetary policy should limit the yen's upside.
The dollar has rallied smartly against the yen for more than a month on expectations that Japan's newly elected government would push the Bank of Japan, headed by Gov. Masaaki Shirakawa, to adopt more forceful monetary stimulus measures.
After gaining about 5.8 percent since December, the dollar fell for a second straight session.
"Mainly, this is due to speculation that the Bank of Japan would fail to meet heightened expectations for a significantly dovish monetary policy," said Christopher Vecchio, currency analyst at DailyFX in New York.
Furthermore, the result of the upcoming BOJ policy meeting may already be priced in, he said.
"Be that as it may, the Japanese yen is simply a very oversold currency," he said.
The dollar fell to a session low of 86.95 yen after a rally of nearly 12 percent in recent months that saw the dollar touch its highest level since July 2010.
It was last at 86.90 yen, with solid support expected at around 86.53, the low hit on Jan. 1.
Analysts said investors were nervous about pushing the yen too much lower due to the risk the BOJ may not opt for aggressive stimulus as early as its next meeting on Jan. 21-22, with a focus on Shirakawa's tenure at the helm of the Japanese central bank.
"We still have Shirakawa, who is not leaving until end of March, so there is a risk of disappointment," said Chris Turner, head of FX strategy at ING in London.
The euro initially gained against the yen after Japanese Finance Minister Taro Aso said the government would buy bonds issued by the European Stability Mechanism (ESM), the euro zone's permanent bailout fund.
The euro, however, eventually dropped against the yen because while Japan buying ESM bonds is supportive for Europe, the country holds mostly dollars and euros in reserves, which makes its weakening impact on the yen unclear.
The euro was at 113.67 yen, having earlier hit a session high of 115.21 yen after Aso's comments.
"Japan's comments helped euro and dollar/yen a bit higher at first. But then everyone realized they are just going to use current reserves so there should actually be no impact," said Geoff Kendrick, FX strategist at Nomura, of the market reaction to the plans to buy ESM bonds.
Euro Falls Ahead of ECB Meeting
The euro was down 0.3 percent on the day against the dollar at $1.3078, but above a three-week low of $1.2997 set on Friday.
Markets are positioned for the European Central Bank to keep rates on hold when it meets Thursday. The single currency was volatile on market talk that France's sovereign debt rating would be imminently downgraded, but the impact was fleeting. A French Finance Ministry spokeswoman on her Twitter feed called the rumors "unfounded and false."
With no significant economic data this week, the euro was seen staying in a range ahead of the ECB meeting and Spanish and Italian bond auctions toward the end of the week.
However, any hint by ECB policymakers about future interest rate cuts could undermine the currency.
"Markets have backed away from peripheral issues in Europe for now, and unless we start to get broader concerns, euro/dollar will continue to trade sideways for now," said Geoff Kendrick, FX strategist at Nomura in London.