NEW YORK (Reuters) - The yen rose sharply versus the euro and U.S. dollar on Tuesday after the Bank of Japan refrained from making additional moves to curb recent bond market volatility, raising doubts over its commitment to easy monetary policy aimed at boosting growth.
The lack of action by the BOJ to try to reduce wide price swings in the local bond market had a cascading effect of sending stock prices sharply lower in Tokyo and setting a negative tone throughout global markets for the trading day.
Japan's Nikkei index, with which dollar/yen has been closely correlated in recent weeks, closed down 1.5 percent .N225.
In the currency markets, the yen's 3 percent rise against the greenback, and nearly as much against the euro, was fuelled by an unwinding of some hefty bets against the Japanese currency after the BOJ announced a $1.4 trillion stimulus program in early April. Loose monetary policy typically leads to a weaker currency.
During the New York trading session the yen buying accelerated after a weak auction for U.S. 3-year Treasury notes, which briefly caused a spike higher in yields.
"I think that scared the market ... as soon as investors saw a bit of pressure on yields it led investors to sell equities and position cutting across the board, including foreign exchange," said Steven Englander, global head of currency strategy at CitiFX in New York.
A subsequent report from the Nikkei News Service saying Japan's Financial Services Agency plans to force losses on investors of troubled financial institutions, if necessary, to reduce the burden on taxpayers, was cited as a contributing factor to yen buying but not the main late day fuel for the rally.
"Generally FX markets have been fairly volatile and choppy, liquidity is even more poor than usual on a summer afternoon," said Brian Daingerfield, currency strategist at RBS in Stamford, Connecticut.
"While those events (auction and Nikkei story) may have been catalysts for the move lower, the reasons behind the overall strength in the yen this afternoon in New York were more due to positioning and low liquidity," said Daingerfield.
Japan's currency strengthened to 95.60 against the greenback, a gain of more than three percent which marked its biggest one-day percentage move since March 16, 2011. At the end of the day, the dollar traded at 96.04, off 2.73 percent.
The euro fell to a low of 127.07 yen before recovering to 130.91, a loss of 2.32 percent on the day.
Much of the move for the yen happened during Asian and European trading hours after the BOJ held off extending the maximum duration of its fixed-rate loans. Some had expected it to stretch the duration to two years from one.
The BoJ's restraint had a global impact as well, causing world equity markets, bond prices and commodities to slump as investors feared that major central banks are cooling their commitment to the money-pumping that has buoyed markets.
Analysts point to the sell-off in emerging markets as another factor for general uneasiness percolating through global markets, fuelled in part by the sign of restraint from the BOJ.
Many investments in these emerging market currencies were funded in yen, which can be borrowed for interest rates that are among the lowest in the world.
In the options market, one-month dollar/yen implied volatility, a measure of expected price swings and a gauge of options pricing, traded near its highest level in more than a year at around 15 percent.
Most analysts expect yen weakness to return as the BoJ's aggressive stimulus is contrasted eventually with the U.S. Federal Reserve's asset purchase program. Last week's relatively healthy U.S. nonfarm payrolls report has spurred expectations that the Fed will start reducing its monthly purchases of $85 billion per month later this year.
The Fed's bond-buying program is viewed as negative for the dollar as it is tantamount to printing money.
Germany's Constitutional Court, meanwhile, started a two-day hearing on the legality of the European Central Bank bond-buying scheme that has defused the euro zone debt crisis. <GVD/EUR>
A ruling is not expected until after German general elections in September, but investors were nervous that Bundesbank chief Jens Weidmann, who will attend the court hearing, could reiterate his opposition to the ECB program.
The euro touched a high of $1.3317 and hovered there with a gain of 0.45 percent. The gains, which put it at its highest point since late February, came after European Central Bank executive board member Joerg Asmussen told the court that the ECB's bond-buying scheme must be unlimited to show the ECB is serious about defending price stability but is in effect limited by its focus on shorter maturity bonds.
Meanwhile, the higher-yielding Australian dollar slid sharply to hit its lowest since September 2010 at $0.9324, according to Reuters data.