The dollar slipped against the major currencies on Tuesday as U.S. bond yields continued to retreat from five-year highs hit last week, eroding their appeal to foreign investors.
At the same time, the euro retreated from a record peak against the yen and treaded water against the dollar after a surprising decline in German business confidence in June.
In recent weeks, the dollar has closely tracked Treasury yields, hitching a ride higher as strong U.S. economic data boosted the benchmark 10-year note's yield to 5.33 percent and sent the euro to almost a three-month low against the greenback.
But with little major U.S. economic data on tap this week to guide traders, a bond market retracement has curbed the dollar's gains and weakened the case for the Federal Reserve to boost interest rates in 2007.
"We have a light calendar this week and there's no real catalyst providing a fresh reason to buy dollars," said Bank of New York strategist Michael Woolfolk. That leaves "significant gyrations in bond prices" to lead some price action, he said.
Higher U.S. Treasury yields imply higher interest rates and tend to attract return-hungry investors into U.S. assets.
But since closing at 5.29 percent a week ago, 10-year note yields have slipped nearly 20 basis points over the past five sessions, the bond market's best five-day stretch in more than three months.
The spread of the implied U.S. interest rate in December 2008 over the euro zone's has narrowed to about 60 basis points from 70 basis points last week, according to futures markets.
Mid-afternoon, the dollar fell 0.2 percent to 123.38 yen and slipped 0.3 percent against sterling to $1.9885 per pound.
An unexpected slide in Germany's ZEW business sentiment index on Tuesday kept the euro's gains more modest, rising 0.1 percent to $1.3423.
The ZEW report also knocked the euro down 0.2 percent to 165.55 yen after it earlier hit a record peak above 166 yen.
Markets are still expecting at least two more interest-rate hikes from the European Central Bank this year, while the Fed is seen leaving rates steady at 5.25 percent for 2007.
"The euro wants to trade higher but can't because of selling pressure in euro/yen," said Brian Dolan, head of research at Forex.com in Bedminster, New Jersey.
Carry Continues, Bond Ties to Weaken
Despite the yen's mild rise on Tuesday, market sentiment remained positioned against the currency as investors continued to borrow it at low Japanese interest rates in order to buy higher-yielding currencies.
Hiroshi Watanabe, Japan's vice finance minister, said Tuesday he was watching speculative yen carry trades carefully but said they do not as yet pose a risk to Japan's economy.
He also said Japan has no plans to diversify its foreign-exchange reserves away from dollars any time soon.
Bank of New York's Woolfolk, however, said it would be a mistake to expect yields and the dollar to march in lockstep indefinitely, adding there are other reasons for the dollar's weakness as well, including a jump in oil prices.
Commodity currencies such as the Canadian and New Zealand dollars have been among the session's biggest gainers, with the former up 0.9 percent from late Monday.
"We should not confuse correlation with causation," he said.