The U.S. dollar slipped against the yen, as Japan's currency rose versus the greenback and other higher-yielding currencies for a second day, with investors shying away from risky assets amid deepening concerns over the credit turmoil and tightening liquidity.
An unexpected interest rate cut by the Bank of Canada and expectations that the Bank of England could follow suit later this week supported the view that central banks were becoming increasingly worried by the credit crisis.
The BoC cited expectations of more global financial market difficulties linked to the U.S. subprime mortgage market rout for its decision to cut its overnight lending rate 25 basis points to 4.25 percent.
"Risk appetite remains very cautious at the moment. There isn't a really strong compelling reason for investors to hold too much risk right now going into year-end, when liquidity typically tightens up," said Mike Moran, senior currency strategist at Standard Chartered Bank in New York.
In early New York afternoon trade, the dollar was down 0.6 percent at 109.87 yen after touching a session low of 109.58.
The high-yielding Australian dollar fell about 1.3 percent to 95.92 yen as investors reversed carry trade bets.
In carry trades, investors borrow in lower-yielding currencies, such as the yen, to fund purchases in higher yielding assets.
The euro was up 0.6 percent at $1.4755 , with traders saying the move higher was accentuated by the break through key stop-loss levels.
The surprise BoC decision sent the Canadian dollar tumbling. The U.S. dollar jumped to a near 11-week high of C$1.0152 and was last at C$1.0120, up 1.2 percent on the day.
Market attention now turns to the Bank of England rate decision due Thursday, with analysts saying chances of a rate cut have risen since the Bank of Canada's move.
"While it is likely too risky for the RBA (Australia) to follow suit, the BoE and ECB could just as easily surprise markets on Thursday with 25 basis points rate cuts of their own," said Michael Woolfolk, senior currency strategist at Bank of New York.
Sterling traded down 0.4 percent at $2.0577, while the Australian dollar against the greenback fell 0.8 percent to US$0.8732.
The Federal Reserve is expected to cut U.S. rates by 25 basis points next week, with some analysts forecasting a 50-basis-point reduction.
"We still believe the Fed will go 25 rather than 50, clearly because 50 basis points might get the market even more concerned than it actually is on the downside risks to growth," said Standard Chartered's Moran.
Liquidity in some credit markets is now at its tightest in years, as banks' risk aversion and reluctance to lend are exacerbated by a seasonal lack of liquidity.
One-month interbank lending rates in the euro (Euribor) rose to near seven-year highs Tuesday, while one-month sterling London interbank rates (Libor) fixed at a 9-year high.