The yen rose broadly on Thursday on worries that the worst from the U.S. subprime mortgage market fallout was yet to come after Bear Stearns recorded its first-ever quarterly loss.
Concerns that the credit market crisis was spreading to other market segments were heightened late on Wednesday, with Standard & Poor's cutting its outlook for bond insurers Ambac Financial Group, MBIA Insurance Corp and XL Capital Assurance.
"That's feeding market fear that the credit market crisis is not contained and is starting to affect more markets. In that environment, investors would not like to take more risk ahead of year end," said Matthew Strauss, senior currency strategist at RBC Capital Markets in Toronto.
The dollar was down 0.5 percent at 112.84 yen, a session low, while the euro dropped 0.7 percent to 161.82 yen.
The yen shrugged off the Bank of Japan's decision to leave interest rates on hold and downgrading of its economic outlook. It also got a lift from a Chinese interest rate hike.
The greenback hit four-month highs versus sterling, after breaking the psychologically key $2 mark the previous session after the release of minutes from a Bank of England meeting suggested it may cut rates again as soon as January.
In contrast, expectations of Federal Reserve rate cuts next year have been slightly scaled down in the wake of last week's unexpectedly strong U.S. economic data.
Sterling fell to a four-month low of $1.9813 and was last trading at $1.9827, down 0.7 percent on the day. The euro rose 0.5 percent to 72.32 pence, close to a 4-1/2-year high above 72.40 pence.
Liquidity was thinning ahead of the year-end holiday season, exaggerating price moves, analysts said.
Morgan Stanley on Wednesday reported a $9.4 billion loss in subprime mortgages and other assets. Bear Stearns followed that up on Thursday by posting its first quarterly loss of $854 million and took a write-down of $1.9 billion in the quarter ended November.
"There is an increase in risk aversion. Yesterday, we had a number of news pieces that were all negative and highlighted the ongoing unknowns from the subprime and credit market turmoil. We expect a sharp rise in the yen," said Brian Dolan, chief currency strategist at Forex.com in Bedminster, New Jersey.
Low yielding currencies such as the yen tend to attract flows during periods of uncertainty as the low interest rates reflect the capital surplus of their respective countries.
The continuation of position adjusting and some repatriation of funds as the year winds down supported the dollar against the euro, lifting it to a two-month peak of $1.4310 per euro in overnight trade.
The euro was down 0.3 percent at $1.4334. The dollar index, which tracks, the greenback's performance against a basket of major currencies was up 0.2 percent at 77.711. It earlier rose to its highest level since late October at 77.854.
Analysts also attributed the greenback's rise to the European Central Bank's $500 billion loan this week to euro zone banks in two-week funds at about 4.21 percent, saying some institutions might have borrowed euros and converted them into dollars.
The rate for the Federal Reserve's $20 billion auction was 4.65 percent.
"The dollar is doing well against most of the majors and behind that is more year-end activity ... repatriation of profits into the U.S. and the squaring of short positions," said RBC Capital Markets' Strauss.