The Japanese yen strengthened broadly on Monday, hitting a two-and-a-half year peak versus the dollar as a rout in global stocks prompted investors to sharply reduce their exposure to risky, higher-yielding assets.
This meant the low-yielding yen, which many investors had used to fund purchases of currencies offering higher returns in so-called carry trades, bounced strongly against major units.
The selloff in stocks was broad and deep, with major European and Asian markets down as much as 6 percent. Investors rushed for the safest and most liquid assets they could find, such as government bonds, which pushed two-year euro zone bond yields down more than 10 basis points on the day and well on track for the steepest monthly decline in over a decade.
The moves were fuelled by worries that the fiscal stimulus package worth up to $150 billion floated by President George W. Bush on Friday will not be enough to shore up a U.S. economy that is feared to be either close to, or already in recession.
"Equity markets have collapsed by over 5 percent in Asia and European equities are now following with even steeper falls in some cases. The disastrous equity and credit market performance provides clear evidence of the fast erosion of risk appetite, with the carry trade now being severely squeezed," BNP currency strategists wrote in a note on Monday.
"With recession fears in the U.S. rising and little confidence in the Bush Administration's fiscal plans, together with the continued broadening of subprime related losses we see little scope for stabilisation in higher risk asset classes."
The dollar was down against the yen at 106.00 yen, having hit 105.69 yen earlier, a level last seen in May 2005.
The euro also fell versus the yen, having dipped below 153 yen earlier for the first time in five months.
Pump Up the Vols
The dollar climbed against a basket of currencies, thanks more to the broad weakness of most other currencies rather than investors' appetite to hold the greenback itself.
"In our view, the balance of negative economic surprises will shift away from the U.S. and re-coupling will increasingly become the main macro theme of the year," said Dresdner Kleinwort in a client note.
Futures markets are betting on the Federal Reserve slashing U.S. interest rates this year to 2.50 percent or lower, including as much as a 75 basis point cut at the bank's policy meeting next week.
This aggressive pricing has now spilled over into European markets, where rates futures are now discounting more than 50 basis points of easing from the European Central Bank this year compared with expectations at the start of the month of the bank staying on hold at 4 percent all year.
The euro fell against the dollar, slipping below $1.45 for the first time in almost a month.
The euro's lurch lower -- Citigroup opened a short euro/dollar position on Monday -- helped push up option market volatility.
Implied volatility on one-month euro/dollar options contracts, a key measure of expected price swings in the euro's exchange rate against the dollar, rose on Monday above 10 percent for the first time in three years.
Implied volatility is the price fluctuation in an underlying asset that the options market expects over a given timeframe.
Monday's choppy moves were on thinner volumes than usual, with U.S. markets closed for the Martin Luther King Jr holiday.