The dollar fell against the yen Friday, as investors shunned risky trades such as stocks and high-yielding currencies after a brokerage downgrade of the top two U.S. home-funding companies, Fannie Mae and Freddie Mac.
The downgrade underscored the deteriorating conditions in the financial services sector and heightened U.S. recession fears, analysts said, especially in the wake of Thursday's data showing a steep plunge in regional factory activity.
In times of risk aversion, investors tend to buy the yen back as they unwind carry trades in which they sell low-yielding currencies to purchase high-yielding units.
"The stock market is struggling today; that's why we're seeing the yen gain a little bit. We're also seeing gains in the Aussie and Kiwi coming off as well," said Nick Bennenbroek, head currency strategist at Wells Fargo in New York.
The dollar was also under pressure Friday, falling to three-week lows against the euro, as Thursday's contraction in the Philadelphia Federal Reserve Bank's Mid-Atlantic business activity index stoked recession concerns, in contrast to the euro zone's surprising growth in the service sector reported on Friday.
But gains in the euro eased after traders sold the single currency versus the yen amid weakness in the stock market. U.S. equities were weighed down by the downgrade on Fannie Mae and Freddie Mac , sparking a sell-off in financial shares.
In midday trading, the dollar fell 0.3 percent to 106.94 yen.
The euro slid 0.2 percent versus the Japanese currency to 158.64 yen.
Losses in the euro against the yen spilled over to the euro/dollar pair, which erased some gains sparked by above-forecast euro zone services sector data earlier.
ECB Rate Outlook
The euro zone services PMI index rose to 52.3 in February from 50.6 the previous month, a survey showed on Friday. The data dampened expectations of near-term rate cuts from the European Central Bank.
The euro had earlier risen to a three-week high of $1.4861 against the dollar on the PMI data, before trading down to $1.4821, still up slightly on the day.
Investors now see less than a 50 percent chance of an ECB easing by July, compared with pricing in almost two cuts on that time horizon two weeks ago.
In contrast, rate futures markets are fully pricing in a half percentage point cut at the Federal Reserve's next meeting in March to 2.50 percent and factor in a small chance of a bigger 75 basis points reduction.
That would add to an unusually aggressive 125 basis points of cuts in January, as the Fed tries to stave off a U.S. recession.
Pesimmism about the U.S. economy intensified after the Philadelphia Fed said on Thursday its business activity index fell to minus 24 in February, the deepest contraction since 2001, shocking many economists who had forecast minus 11.
"A similar dramatic drop in the Philly Fed is usually associated with a recession. Regardless of whether it actually turns out to be a technical recession, the important part from here is how deep does the slowdown go and how long does it last," said Scotia Capital in a research note.
The rise in the euro dragged down the dollar index to near three-week lows of 75.357. The index last traded at 75.500, 0.1 percent weaker on the day. It was down about 0.7 percent on the week at current prices.
The Canadian dollar , meanwhile, weakened after a domestic retail sales report missed expectations and supported the case for more rate cuts from the Bank of Canada. In midday trade, the U.S. dollar rose 0.2 percent against the Canadian currency to C$1.0134.