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Dollar Falls Against Yen As China Growth Raises Rate Hike Concerns

The dollar and euro fell against the yen after as worries about a possible near-term interest rate hike in China to slow its accelerating economy prompted investors to unwind trades funded by low rates in the Japanese currency.

Any slowdown in China as a result of higher rates could crimp demand for emerging market and other risky assets that have supported the carry trade, a strategy in which investors borrow cheaply to buy higher-yielding assets or currencies.

The yen trimmed earlier gains against high-yielding currencies such as the U.S., Australian and New Zealand dollars but most analysts saw that as a temporary setback for the yen.

"Demand for carry trades fell this morning, with the yen rebounding against most major currencies, said Samarjit Shankar, a director for foreign exchange at Mellon Financial in Boston. "It's a knee-jerk reaction to the possibility of higher interest rates in China."

In early afternoon trading, the euro was slightly lower on the day against the yen, after having fallen as much as 1%. The dollar recovered from lows of 117.62 yen.

The Australian dollar trimmed losses against the yen, but was off a decade high above 100 yen hit this week. The New Zealand dollar also came off lows at 88.05 yen along with sterling, which came back from intraday lows of 235.27.

"The setback this morning is temporary and in fact the markets have since recovered," said Aston Chan, an investment analyst at hedge fund GLC Global Macro Fund in London.

"European equity markets opened much lower and they have all come back. Even the (high-yielding) Aussie dollar has recovered from its lows against the yen," he added.

Data showed that China's economy grew at a blistering 11.1% annual pace in the first quarter and March inflation rose above the central bank's 3% comfort level.

The numbers fueled speculation that interest rates would need to rise again soon to tighten credit, a view enhanced by Premier Wen Jiabao's comments that the country needed to take measures to prevent economic overheating.

China's robust economy has contributed to strong growth in emerging economies that export commodities, raising concerns that any slowdown in the world's fourth-largest economy would
reduce demand for emerging market assets generally.

Chinese stocks lost 4.5% on Thursday, the sharpest drop since Feb. 27 when the Shanghai Composite Index slumped 9%, roiling world markets. Equity markets in Asia and Europe fell, adding to expectations investors will unwind carry trades.

The drop in Chinese stocks sent global stocks lower and government bonds in Europe and the United States higher. In afternoon trading, U.S. stock indexes were flat.

Mellon's Shankar added that somewhat resilient U.S. stock and bond markets helped offset the slump in the greenback after a tumble in Europe and Asia.

Sterling was down after hitting a 26-year peak on Wednesday.

The euro was flat after notching a two-year high of $1.3619 earlier in the day and still in sight of the record high at $1.3670 set in December 2004.

There was no reaction in currency markets to news the Philadelphia Fed's index of business conditions in the U.S. Mid-Atlantic region was unchanged in April after economists had expected a stronger result.

"What this does is add pressure to an already weak dollar profile," said Charmaine Buskas, FX analyst at Moody's Economy.com in Pennsylvania. "It suggests that manufacturing activity is decelerating and that just lends further evidence to the slowdown in the U.S. economy.