LONDON (Reuters) - The yen rose against the dollar on Monday from a 2-1/2 year low, with traders trimming large bets against the currency in case monetary easing measures expected from the Bank of Japan are disappointing.
The yen is likely to stay firm until the BOJ's policy decision is known when the two-day meeting ends on Tuesday. The central bank, which is expected to double its inflation target and increase its asset purchase program, said it would begin the meeting earlier than usual.
Traders and analysts said if the BOJ met expectations then the dollar would lose a bit more ground, given the huge gains it has made since October and investors such as hedge funds would be keen to book profits.
Short yen positions were significantly large before the BOJ meeting. Financial markets are expecting a joint statement from the bank and the government to announce a 2 percent inflation target, an increase in asset purchases with an open-ended commitment, and possibly other measures.
The dollar was down 0.5 percent on the day against the yen at 89.60 yen with volumes thin because of a US holiday. It had earlier touched 90.25 yen, its highest since June 2010, only to retreat.
"We see a bit of short covering going into the BOJ meeting with people being a little mindful that there could be some disappointment," Jeremy Stretch head of currency strategy at CIBC World Markets.
"Investors are being mindful that the moves we have seen over the course of the last month or two are just worth locking in at least until we understand how the BOJ are really going to play in the future."
Chartists cited support for the dollar near 89.10 yen, the low hit on January 14, and said if it stayed above that investors would still see it as a good opportunity to buy dollars on dips.
Since mid-November, the dollar has risen about 13 percent while the euro has risen about 20 percent against the Japanese currency as speculators and long-term investors turned overwhelmingly negative on the currency.
"It is reasonable that some of the investors are closing record short yen positions ahead of the meeting," said Carl Hammer, chief currency strategist at SEB Merchant Banking.
He said that while the dollar would be headed higher against the yen this year, there was room for correction in the near term, leaving the dollar to trade between 86-88 yen in the one-month horizon.
Against the yen, the euro fell 0.4 percent to 119.35 yen, off a 20-month peak of 120.73 hit last week, while the Australian dollar shed 0.4 percent to 94.19 yen, slipping from a four-year high of 95.02 set Friday.
Some of the nervousness in the currency market before the BOJ decision was reflected in the options market where overnight implied volatilities in dollar/yen jumped to 28 percent from around 15.3 percent late last week.
"The market is worried about the BOJ outcome," said an options trader at an European bank. "Investors have built positions in anticipation of the BOJ decision. If dollar/yen falls after the event, we could see near term vols ease."
The cost of hedging against yen weakness in the options market has been rising since late last year. So if the yen earns a temporary reprieve after the BOJ decision it could ease some of the upward pressure on hedging costs, traders said.
Meanwhile, the euro was flat on the day at $1.3310, having been capped by the $1.3400 level in the past week with traders citing stop-loss sell orders under $1.3280 and $1.3250.
Strategists said the euro was likely to remain firm over the next few sessions as concerns around the euro zone crisis continued to ease, unless sentiment data later this week surprised to the downside. <ECI/EURO>
The Bundesbank said on Monday that Germany's economic slump should be short-lived, adding that euro zone's largest economy could have already bottomed out.
Data on Friday showed currency speculators increased their bets against the U.S. dollar and went long on the euro, helped by European Central Bank chief Mario Draghi's comments that prospects in the euro zone were starting to improve. <IMM/FX>
(Additional reporting by Anirban Nag; Editing by Toby Chopra)