Yen surges as credit woes take toll on stocks

NEW YORK (Reuters) - The yen surged across the board on Tuesday as growing turmoil in U.S. credit markets led investors to bail out of stocks and risky trades financed by borrowing in the Japanese currency.

The yen rallied sharply as mounting worries about the housing market drove some major U.S. stock indexes down nearly 2 percent by the close. The dollar also sank to a record low against the euro and a 15-year trough against a basket of major currencies.

"We're teetering very close to the edge of a carry trade unwind, and my personal view is that there are reasons to bail out right now," said Camilla Sutton, foreign exchange strategist at Scotia Capital in Toronto.

The yen, the lowest-yielding currency in the industrialized world, has been a popular financing vehicle for speculators investing in higher-yielding assets of countries such as Australia and New Zealand through so-called carry trades.

As investors unwound some of those bets, the yen fell 1 percent against the currencies of both countries on Tuesday.

The dollar sank 0.7 percent to 120.25 yen after touching a two-month low of 120.03 yen. Meanwhile, the euro dropped 0.6 percent to 166.20 yen.

The dollar index, a gauge of the dollar's value against a basket of six major currencies, dropped to a low of 80.016 .DXY, near the psychologically significant level of 80.00.

A break below 80 in the dollar index and 120 in the dollar/yen exchange rate would likely trigger a wave of new sell orders, accelerating the dollar's decline, traders said.

With five trading days left in July, the dollar index is on pace for its biggest monthly decline since November 2006.

The euro jumped to a record high of $1.3853, according to electronic platform EBS, before settling back at $1.3820, up 0.1 percent on the day. Sterling climbed to a 26-year high of around $2.0655.

SPOTLIGHT ON YEN

Before leading the charge on Tuesday, the yen had been pummeled to record lows against the euro and 18-year lows against the Australian dollar.

The Bank of Japan is expected to raise interest rates at only a glacial pace this year, posing little threat to the carry trade. But worries that weakness in the U.S. subprime mortgage market is spreading to the wider economy could cause a flight from risky assets -- leading to a rush to buy back yen.

"Fears that USD/JPY may be the weakest link in the carry trade appear to be coming home to roost," Alan Ruskin, chief international strategist at RBS Greenwich Capital, wrote in an e-mail to clients. "This is a move that has nothing to do with Japan fundamentals, and everything to do with the corrosive impact of credit on the dollar and dollar/yen in particular."

If problems stemming from the subprime market spread to other sectors, foreign demand for U.S. corporate debt -- a major source of financing for the trade deficit -- could waver and further hurt the dollar, some analysts say.

Given the market's sensitivity about the health of the housing market, U.S. existing home sales data due on Wednesday and new homes sales due on Thursday are likely to be major centers of attention this week.

Both precede the first reading of second-quarter U.S. gross domestic product, due on Friday, which will indicate to what extent the economy bounced back from the January-March period, it most sluggish quarter of economic growth in more than four years.

The latest plunge lower in the dollar coincided with a report showing Canadian retail sales in May had the biggest increase in nearly a decade, pushing the greenback to a 30-year low against the Canadian dollar of C$1.0341.

(Additional reporting by Kevin Plumberg)