Dollar Declines to 2 1/2-Year Low Against Yen on Credit Losses

By Lukanyo Mnyanda and Ron Harui

. 16 (Bloomberg) -- The dollar fell to a 2 1/2-year low against the yen as losses in credit markets widened and the U.S. showed more signs of sinking into recession.

The U.S. currency fell the most versus the yen and the Swiss franc on expectations Merrill Lynch & Co. and JPMorgan Chase & Co. will follow Citigroup Inc. in writing down the value of investments linked to U.S. mortgages. The yen climbed against Canadian dollar and the South Korean won as a slump in global stocks prompted investors to repay loans in the currency used to buy higher-yielding assets.

``Further weakness is in store for the dollar as financial companies underperform,'' said Kamal Sharma, a London-based currency strategist at Bank of America Corp. ``The equity markets are shaky and the yen should remain robust.''

The dollar dropped to 106.11 yen as of 9:35 a.m. in London, from 106.78 yesterday in New York. It touched 105.97, its first time below 106 since May 2005. The U.S. currency also traded at $1.4816 per euro from $1.4804 yesterday, when the euro reached $1.4922, the strongest since the record high of $1.4967 in November. The Swiss franc reached an all-time high of 1.0838 per dollar.

The yen rose to 157.21 per euro after reaching 157.20, the strongest since Sept. 11, from 158.08 yesterday. It also climbed 0.8 percent to 93.32 versus Australia's dollar and 1.25 percent to 81.93 against New Zealand's dollar. The MSCI Asia-Pacific Index of regional shares fell 3.6 percent.

Merrill will post a fourth-quarter loss of $3.23 billion tomorrow, while JPMorgan will report today a 29 percent drop in earnings to $3.21 billion, analysts estimate.

Fed Rate Bets

Bank of America Corp. lowered its forecast for the dollar in a research note yesterday because of market expectations for a recession. The second-largest U.S. bank cut its outlook for March 31 to $1.48 from $1.45 previously and to 109 yen from 112.

Fed funds futures contracts on the Chicago Board of Trade show a 100 percent likelihood the Fed will lower the target overnight lending rate between banks by at least a half- percentage point to 3.75 percent on Jan. 30. The chance of a cut to 3.5 percent is 40 percent, compared with zero a week ago.

The Fed may say today that industrial production fell 0.2 percent in December, after a 0.3 percent increase in November, according to a Bloomberg News survey of economists before the report due at 9:15 a.m. in Washington.

The Japanese currency reached the highest in four months versus the euro as rising volatility spurred investors to sell higher-yielding assets. Japan's benchmark interest rate of 0.5 percent compares with 4 percent in the 15-nation euro region and 8.25 percent in New Zealand.

`Cutting Foreign Assets'

``Investors don't want to take risks at this stage, with some of them probably cutting foreign assets,'' said Seiichiro Muta, director of foreign exchange in Tokyo at UBS AG, the world's second-largest currency trader. The yen may advance to 157 per euro today, he forecast.

Volatility implied by one-month dollar-yen options rose to 14.75 percent, the highest since Nov. 27, from 13.65 percent yesterday. An increase in volatility may discourage carry trades as it implies greater exchange-rate fluctuation risk.

In carry trades, investors borrow in countries with lower interest rates and invest in those with higher borrowing costs, earning the spread between the two.

The euro extended this month's gain versus the dollar to 1.6 percent before a European report that may show inflation stayed at the highest in more than six years in December, backing the European Central Bank's case for higher interest rates.

ECB `Hawkish'

``The commentary from ECB officials in the past week has clearly been on the hawkish side,'' said John Horner, a currency strategist at Deutsche Bank AG in Sydney, in an interview with Bloomberg television. ``The risk that they see is rates may need to go up further. That should push the euro against the dollar through the $1.50 mark.''

The European Union's statistics office will say at 11 a.m. in Luxembourg the inflation rate in the euro area was 3.1 percent in December, unchanged from the preliminary estimate, according to a Bloomberg News survey of economists.