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Uncertainty About Central Banks' Courses Deflates Dollar

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The yen rose against the U.S. dollar on Friday for a fourth straight day and gained ground versus the euro as investors unwound bets against the Japanese currency due to uncertainty whether central banks will maintain their easy monetary policies.

With the Federal Reserve's next policy meeting just a few days away, there has been increasing focus—and growing uncertainty—over when the U.S. Federal Reserve might pull back from flooding the market with dollars, a policy meant to spur borrowing and investment to bolster a sluggish economy.

(Read More: What Japan Can Teach the Fed About QE Addiction)

In addition, doubts over the Bank of Japan's commitment to its inflationary policies has caused some investors to exit their use of profitable carry trades in the yen. That practice involves using the low-yielding yen to fund purchases of higher-yielding assets, such as U.S. stocks.

"The strength against the euro doesn't surprise me because the dollar and yen strength tend to be consistent with a loss of risk appetite. We are in a more risk-averse mode," said Michael Woolfolk, global markets strategist at BNY Mellon.

"The carry trade has been put on the shelf until we get more certainty on U.S. monetary policy. These short-yen positions that invested in equities and other high yielding assets outside of Japan have been brutalized recently due to a drop in both the Nikkei and the Dow and yen strength," he said.

The Fed will meet on Tuesday and Wednesday, and the U.S. central bank's policy statement that will be released at the close of the meeting and the news conference by Fed chief Ben Bernanke will be scrutinized for clues on when the Fed might start to pull back on its stimulus program.

The euro fell against both the yen and greenback on Friday.

Trading in the dollar-yen has been locked in step with Japan's benchmark Nikkei 225 index in recent weeks as investors unravel the sell-yen, buy-stocks trade that dominated the market between November and May.

(Read More: Is an Overconfident BOJ to Blame for Market Woes?)

Japanese benchmark stock prices have fallen for four consecutive weeks, and U.S. stocks are down nearly as much.

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A fall in equities also forces investors to pare the dollar hedges initially put in place to protect them from a weakening yen.

Although the Nikkei rose 1.9 percent on Friday, all three major U.S. stock indexes fell and the yen buying extended into the weekend.

In addition, a survey showing U.S. consumer sentiment retreated this month after reaching its highest level in nearly six years in May favored the safe-haven yen.

(Read More: Consumer Mood Comes Down From May Highs)

"The yen has proved to be investors' go-to safe haven to ride out global stock market volatility," said Joe Manimbo, senior market analyst at Western Union Business Solutions in Washington.

"The uncertainty has prompted investors to exit recently overcrowded plays like betting on the dollar and Japan's Nikkei stock index and against the yen," he said. "With that play now in reverse, the yen has steadily been squeezed higher."

The dollar last traded down 1.07 percent at 94.34 yen, up from a low of 93.99, its lowest point since the BOJ announced on April 4 that it would buy $1.4 trillion in bonds to stimulate its economy.

The euro fell on Friday, dropping 1.28 percent against the yen to 125.89 yen. It hit a session low of 125.17 yen.

The dollar had its worst week against the yen since July 2009, with a decline of 3.3 percent. The euro lost 2.4 percent against the Japanese currency, its worst week since July 2012.

"Until investors get a better handle on the future course for monetary policy in the U.S., Japan and Europe—which could come as soon as next week—the yen should be poised for a continued grind higher," Manimbo said.

After hitting a four-month high of $1.3390 on Thursday, the euro traded down 0.2 percent to $1.3345, according to Reuters data. The dollar index was off 0.13 percent at 80.639, recovering from a four-month low of 80.50 on Thursday.

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