The dollar recovered lost ground against the yen on Wednesday after a sharp sell-off the previous day as investors sought to buy at cheaper levels while remaining focused on central bank stimulus.
Uncertainty on when the U.S. Federal Reserve will pare back its ultra-loose monetary policy weighed on the dollar in early European trade, but traders said investors were buying it at lower levels headed into New York trade given the U.S. economy was in better shape than the euro zone and Japan.
Deleveraging, monetary policy and positioning have been driving markets. "Today, markets are retracing some of the losses suffered in the last few sessions," said Camilla Sutton, chief currency strategist at Scotiabank in Toronto.
"Increasingly, monetary policy appears to have reached its limit in terms of stimulus," she said, noting that the Fed appears to be moving towards stepping out of quantitative easing while the BOJ has aggressive policy in place, but is not eager to add.
"Accordingly there appears to have been a rapid shift to de-lever, which has weighed heavily on emerging market currencies and the carry trade," she said.
"We are seeing a shakeout of the long dollar/short yen trade, given that the BOJ has refrained from taking additional measures," said Mankash Jain, head of FX and Investment Management at hedge fund Solo Capital.
"But we expect the BOJ to address the issue and look to buy dollar/yen at 96 yen, with stops at 95 yen for an eventual move to 99 yen."
Yen shorts were squeezed after the Bank of Japan disappointed investors hoping for an extension in the maximum duration of its fixed-rate loans to try and quell volatility in the bond market. Doubts about the Bank of Japan's commitment to easy monetary policy aimed at boosting growth had caused Japanese stocks to fall and the dollar to drop 3 percent against the yen on Tuesday as investors unwound hefty bets against the Japanese currency.
Global stock markets and emerging market assets were also sold off on Tuesday, hit by expectations that the Federal Reserve may start to taper its bond buying plan later this year. That drove investors to the safety of the most liquid currencies like the yen and the dollar.
Of the two, the yen is preferred during times of market turmoil.
Since the start of this year, speculators and long-term investors have been building favorable dollar positions on the back of good first-quarter U.S. economic data. Some are now trimming those bets and booking profits.
"Q2 U.S. economic data is softer and this appears to be limiting investors' desire to lengthen dollar positions despite the greenback's safe-haven status," Jane Foley, senior strategist at Rabobank wrote in a note.
Given that confidence in the euro zone was better than a year ago, investors were hesitant to build large bets against the common currency. The euro hit a 3 1/2-month high against the dollar in early European trade, rising to $1.3334, before later gave up gains to trade at $1.3288, down 0.2 percent.
The euro remains vulnerable to losses should the region's economy remain in a prolonged recession and if borrowing costs for some of the most indebted euro zone countries rise.
European Central Bank Executive Board member Peter Praet on Tuesday said the ECB had room to cut interest rates further.