The dollar rallied from a 15-year low against a basket of currencies Wednesday, as investors bet the Federal Reserve's interest rate cut Tuesday will help boost a slowing U.S. economy.
The Fed slashed the benchmark federal funds rate to 4.75 percent from 5.25 percent, to help relieve strains in credit markets.
The dollar fell on news of the rate cut because it diminished the greenback's relative yield advantage, but it bounced back on Wednesday as investors took the view that easier monetary policy would improve U.S. economic prospects.
While the dollar initially fell on news of the rate move because it diminished the greenback's yield allure, the currency bounced back as investors took the view that the easier monetary policy improved U.S. economic prospects.
The Fed move also helped to renew risk appetite in some investors, who returned to the carry trade in yen where investors borrow in a low-yielding currency to buy higher-yielding assets elsewhere. All three major U.S. stock indexes rose on Wednesday.
"There is moderate reentry into carry trades, with the yen as the cheap vehicle to purchase U.S. equities," said Greg Salvaggio, vice president of trading at Tempus Consulting in Washington.
In late afternoon trading, the euro fell 0.1 percent to trade at $1.3962.
The dollar was little changed against the yen at 116.07 after trading as high as 116.33 yen.
The dollar index was up 0.15 percent at 79.327 after going as low as 79.091, according to Reuters data.
Traders and analysts, however, said the dollar is expected to weaken in the long term once investors look again at rate differentials.
"Another rate cut by the Fed is now expected before year end, as further narrowing of the interest-rate differential between Europe and the U.S. should keep the dollar under pressure in the near term," said Nick Bennenbroek, head currency strategist at Wells Fargo Bank in New York.
Analysts said risk aversion was lower Wednesday, but investors would likely stay cautious on worries about more bad news tied to the U.S. subprime mortgage crisis and resulting credit market troubles, highlighted by the problems of British mortgage lender Northern Rock.
"Risk appetite is back up and high-yielders are back up as well," said Antje Praefcke, currency strategist at Commerzbank in Frankfurt.
Meanwhile, hours after the Fed's announcement, the Bank of Japan held its overnight rate at 0.5 percent, a widely expected move that prompted limited market reaction. The bank said it will determine the impact of troubles in the United States before considering a rate rise.
The euro was little changed at 162.31 yen after pushing up to a five-week high of 162.56 yen on Tuesday.
Sterling was also under pressure, hitting a 17-month low against the euro for a third consecutive session, as traders interpreted the minutes of this month's Bank of England meeting as signaling possible interest rate cuts in the future.
The British pound fell 0.6 percent against the dollar to $2.0003.
The euro rose to a 17-month peak of 69.97 pence, in the wake of the Bank of England minutes. It last changed hands at 69.83 pence.
Minutes of the Sept. 5 to Sept. 6 meeting published on Wednesday showed MPC members agreed that the upside risks to inflation had receded somewhat as a result of turmoil on financial markets and developments in the real economy.
The New Zealand dollar, whose steep interest rates make it a bellwether of risky carry trades, hit its highest level in more than a month against the dollar, extending gains after posting its biggest one-day rise in nine years following the Fed's move.
The New Zealand dollar climbed 1.2 percent to US$0.7345.
The dollar to the Swiss franc bounced off key support at 1.1800 twice in the global trading session, with bids going as low as 1.1796, according to Reuters data. The pair last changed hands little changed at 1.1848, up 0.4 percent.
Elsewhere the dollar fell almost to parity against the Canadian dollar at C$1.0084, before recovering to trade at C$1.0145, according to Reuters data.
A report showing the U.S. core consumer price index was in line with expectations in August had little impact on foreign exchange trading, coming the day after the Fed's decision.
Similarly, a report showing U.S. home construction starts at their lowest in 12 years in August was largely ignored.