The yen staged its biggest one-day rally in almost a year on Thursday after Japanese monetary authorities offered a surprisingly clear hint at a shift in policy, while the euro headed for its biggest weekly fall since May.
The dollar index eased ahead of Friday's U.S. non-farm payrolls report, under pressure mostly from the yen, which rose by more than 2% to its strongest in three months.
Bank of Japan (BOJ) Governor Kazuo Ueda said on Thursday the central bank has several options on which interest rates to target once it pulls short-term borrowing costs out of negative territory.
Markets took this as a potential sign that change may be imminent and pushed the yen higher.
"The comments last night sort of poured rocket fuel into bets on an eventual move back into positive rates territory for the Bank of Japan," said Karl Schamotta, chief market strategist at Corpay in Toronto.
The dollar was last down 2.4% against the yen at 143.73.
The BOJ has been the lone holdout among central banks, by maintaining a policy of ultra-low rates that sent the yen to its weakest in decades against the dollar and sparked speculation that monetary authorities could intervene to prop up the currency.
"The market is very, very heavily short the yen and we've got a heavy consensus in for 2024 that this is going to be the year that they bring negative rates to an end. So it shows the market is ready to latch on absolutely anything that it can in light of that," TraderX strategist Michael Brown said.
The euro rose 0.3% against the dollar to $1.0794, fueled by a dramatic repricing of interest rate expectations for 2024, although caution around Friday's U.S. non-farm payrolls has kept trading volatility subdued.
Falling inflation, a slowdown in major economies such as Germany and softness in the labor market have prompted traders to assume euro zone rates will fall to 3%, from 4% currently, by September, down from an expectation of 3.4% just two weeks ago.
As a result, the euro has hit eight-year lows against the Swiss franc and three-month lows against the pound this week.
The European Central Bank (ECB) holds its final meeting of 2023 next Thursday.
The dollar index, which shed 3% last month, was down 0.5% at 103.61, not far off a two-week high, with Friday's payrolls the main focus.
"I think we're going to see a slightly softer number relative to expectations, but that this is not going to meaningfully impact expectations for the Fed's policy map," said Schamotta.
"Where I see the volatility term structure should be probably more elevated is around Wednesday's policy meeting."
The Fed is widely expected to maintain rates at the current level when it meets next week. Futures markets are pricing in a 60% chance of a Fed rate cut by March, up from 50% a week ago, according to the CME's FedWatch tool.