The yen dropped to its lowest against the U.S. dollar in more than two years on Thursday on expectations a new government in Tokyo will push for aggressive monetary stimulus to boost a sluggish economy and take steps to weaken the Japanese currency.
The euro, meanwhile, rose for a second straight session and traded above $1.32 for eight consecutive days partly on position-adjustment going into the end of the year and a growing view that euro zone debt tensions have eased.
But on a quiet pre-New Year's week, the focus remained squarely on the yen. Speculators and hedge funds were increasingly looking to sell yen for dollars, traders said. Some said a dollar close above its 200-week moving average of 84.95 yen on Friday — the first since late December 2007 — would be a strong signal of further strength in the U.S. currency.
The dollar rose to 85.92 yen, its highest since August 2010. It was last up 0.4 percent on the day at 85.91 yen with option barriers cited at 86 yen and stop loss buy orders above 86.10 yen.
"Yen weakness, based on expectations that the new Japanese government will succeed in driving the dollar to 90 yen with a combination of more aggressive monetary and fiscal policy, is offering support to other currencies," said Marc Chandler, global head of currency strategy, at Brown Brothers Harriman in New York.
Prime Minister Shinzo Abe, who has threatened to revise a law guaranteeing the Bank of Japan's independence if it refuses to set a 2 percent inflation target, appointed a cabinet of close allies on Wednesday.
The yen has fallen around 10.5 percent versus the dollar in 2012, its biggest annual drop since 2005, with most of that weakness coming in the past two months as expectations mounted Abe will pursue policies to weaken the yen. A weaker yen helps Japanese exports and has already lifted Japanese stocks.
Japan's benchmark Nikkei share average hit a 21-month high on Thursday and has climbed 22 percent this year, putting it on track for its best yearly gain since 2005.
In the options market, risk reversals in dollar/yen showed a further bias towards yen weakness. Risk reversals from one-month up to four-years were skewed towards dollar calls or yen puts, reflecting increased confidence among investors to bet against the Japanese currency.
One-month implied dollar/yen volatility, a gauge of expected moves, rose to 8.5 vols from 7.3 last week, close to the December 13 near-six-month high of around 8.65, highlighting growing demand to hedge against sharp price swings.
The yen touched its lowest level against the euro in nearly 17 months. The euro hit 114.14 yen, its strongest against the yen since early August of 2011.
The euro traded at $1.3274, up 0.4 percent on the day and just below an eight-month high of $1.3308 hit last week. Speculators further trimmed short bets against the single currency as euro zone debt worries ebbed.
Brown Brothers' Chandler said the euro zone's move away from the abyss was clearly due to the European Central Bank and its asset purchase program.
He also cited moves by the European Commission to grant several countries including France and Spain an extra year to reach the 3.0 percent fiscal deficit target.
"An official announcement has not been made, but the signals from the EC and the Commissioner for Economic and Monetary Affairs (Olli) Rehn are unmistakable," Chandler said.
However, euro/dollar moves are also linked to U.S. budget negotiations. A U.S. budget agreement is seen as positive for riskier currencies such as the euro and negative for the safe-haven and highly liquid dollar.
Concerns the U.S. Congress might fail to head off a potentially recession-inducing "fiscal cliff" of tax hikes and spending cuts that are due to kick in next year could cap the single currency's gains.
The dollar index stood at 79.411, down 0.3 percent on the day and above a two-month low of 79.008 hit last week.
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