Dollar sinks in US subprime, credit quicksand

By Jamie McGeever

LONDON (Reuters) - The dollar weakened broadly on Wednesday, striking a record low versus the euro and a 26-year trough against sterling as growing fears surrounding the U.S. subprime mortgage and credit sectors gripped financial markets.

These concerns, heightened on Tuesday after two ratings agencies issued warnings on more than $17 billion of debt linked to risky mortgages, made investors less willing to take on risk.

This helped trigger a sharp selloff in equity markets, slide in bond yields, rise in implied FX volatility and some unwinding of carry trades where low yielders like the yen are sold for higher return units such as the New Zealand dollar.

The Federal Reserve's broad dollar index on Tuesday showed the greenback's nominal, weighted value at its lowest level in a decade. Against a selection of major currencies, the dollar hit its lowest level ever in the free-floating currency period since the Fed's records began in 1973.

But as European trading progressed Wednesday, traders took time out to assess the damage and prices retraced slightly.

"We continue to see two themes play out: the dollar taking the brunt of concerns about credit markets, and whether this should lead to more substantial risk aversion and unwind of carry positions," said Laura Ambroseno, currency strategist at Morgan Stanley in London.

"We've certainly seen that over the last day or so but market participants may not be quite convinced this will be a prolonged unwind, or if the reprieve is a good buying opportunity."

At 1000 GMT the euro was flat on the day at $1.3745, having set a record high of $1.3784, according to Reuters data, earlier in the day.

Sterling was up 0.25 percent at a 26-year peak of $2.0316, while dollar recovered from a one-month low of 121.02 yen to trade at 121.55 yen.

"It looks like markets are taking a breather and licking their wounds now," said one European bank trader.

BOJ EYED

The dollar's sell-off on Tuesday was exacerbated by reports from credit rating agencies Standard & Poor's and Moody's Investors Service on Tuesday that warned on over $17 billion of debt related to risky mortgages, much of it subprime. Subprime loans are extended to borrowers with poor credit.

The effect across financial markets was stark.

Ten-year Treasury yields slumped back below 5 percent, equities tumbled, spreads moved against the dollar and implied volatilities on short-term currency options jumped.

"Clearly with the weakness in equities and concerns about the U.S. housing market it is probably not surprising to see some short covering and unwinding of carry trades. But I would be very cautious to call this a general turn against carry," said Michael Klawitter, currency strategist at Dresdner Kleinwort in Frankfurt.

"I would expect the dollar index to remain under pressure. Euro/dollar risks are clearly for a move towards $1.40."

The dollar index fell to a 2-1/2 year low of 80.627.

Subprime worries prompted market to price in a greater risk of a Federal Reserve interest rate cut this year or next.

"Near term, these credit concerns should drive currencies, and that means the dollar remains under a bit of pressure," said Ambroseno at Morgan Stanley.

In contrast to the Fed, other central banks around the globe are expected to continue tightening monetary policy, with yield differentials thus set to move to the detriment of the dollar.

The Bank of Japan is widely expected to hold interest rates steady on Thursday, although some of the more hawkish members of the board may vote for a hike to 0.75 percent.