The yen rallied against most currencies in volatile trade Monday as concerns about the U.S. mortgage market sparked investors to unwind risky bets such as carry trades funded by the Japanese currency.
Fears that turmoil in the U.S. subprime sector have spilled over into the wider credit markets prompted traders to close carry trades, in which low-yielding currencies were used to buy high-yielding assets. The U.S. and New Zealand dollars slipped as a result.
"The main driver continues to be the high level of risk aversion in the market and investors continue to watch developments in the credit sector," said Omer Esiner, market analyst at Ruesch International in Washington.
"The higher level of risk is benefiting the yen and to some degree the Swiss franc, but is continuing to weigh on the higher-yielding currencies such as the Aussie and the Kiwi (New Zealand dollar)," he added.
A brief rise in European equities on Monday provided some respite but risk aversion soon returned as stock markets turned lower and the iTraxx Crossover index of mostly junk-rated bonds widened to a record 500 basis points.
The yen hit roughly three-month highs of around 118.05 per dollar and 160.67 per euro, according to Reuters data. By early New York session, the dollar was still up slightly on the day against the Japanese currency, while the euro crawled higher too.
Trading was volatile, with the dollar moving in a one-yen range and the euro in a two-yen range.
The yen also broadly shrugged off a crushing defeat for Japanese Prime Minister Shinzo Abe's ruling camp in upper house elections on Sunday that threatened policy gridlock, with the conservative leader vowing to stay in his post.
The Swiss franc, another low-yielding funding currency, rose half a percent against the dollar to 1.2021 francs and about 0.1% versus the euro to 1.6453.
The euro was up against the dollar, as was sterling . Australian and New Zealand dollars slipped to one-month lows against the greenback to U.S. $0.8460 and U.S. $0.7555.
As risk reduction rocked financial markets last week, the Aussie dollar posted its biggest weekly decline against the U.S. dollar in 2-1/2 years, and the kiwi dollar its biggest weekly slide in 3 years.
While credit worries will dominate sentiment, there's a heavy data flow this week too. July non-farm payrolls, global purchasing managers' indices, the Chicago PMI and interest rate decisions from the European Central Bank and Bank of England could all move currencies.
The ECB and BoE are expected to keep rates on hold at 4% and 5.75% this week, respectively, although both are still seen raising rates at least once more this year.
"A deteriorating growth outlook is perhaps the most serious risk to the risk appetite environment and this is more likely after last week's extremely poor U.S. housing data, so this week's regional PMIs and non-farm payrolls report will be important," wrote RBS strategists in a client note on Monday.