FOREX-Yen edges lower as Fed injection eases credit fears

(Updates prices, adds comment)

By David McMahon

NEW YORK, Aug 10 (Reuters) - The yen drifted lower against the dollar and euro in volatile trading after the Federal Reserve injected cash into the banking system for a third time on Friday, underpinning U.S. stocks and soothing nervous financial markets.

Global central banks, including the European Central Bank and Bank of Japan, have added more than $300 billion of extra cash to the banking system to stabilize credit markets over the past two days.

That helped U.S. stocks temper sharp losses and sent currency traders scrambling to sell yen they had been buying back only hours earlier in response to the stock declines.

The yen often slips when equity markets are buoyant because investors can borrow in low-yielding yen to finance purchases of stocks and other risky assets. When stocks slide, the yen tends to firm as investors unwind those yen carry trades.

"Central banks like the Fed and ECB are adding liquidity and that has done a lot to calm the markets," said Rafael Martorell, chief dealer at BNP Paribas in New York.

The Dow Jones industrial average .DJI was down 0.6 percent in late afternoon trade but well off the day's lows.

A crisis that began months ago with losses in the U.S. subprime mortgage market has metamorphosed into a worldwide flight away from risk. Equities have tumbled this week, government bonds have rallied and expectations of global central bank tightening have been drastically scaled back.

On Friday, the Fed injected $38 billion of funds into the banking system and said it was ready to supply funds as needed to financial markets -- the first such reassurance from the central bank since Sept. 11, 2001.

In mid-afternoon New York trading, the dollar was up 0.1 percent at 118.30 yen JPY=, more than one yen above a low touched earlier in the session. The greenback also rose 0.1 percent against the Swiss franc to 1.1974 francs CHF=.

The euro was up 0.2 percent on the day against the dollar at $1.3698 EUR=, still well below a record high of around $1.3850 hit last month. It was up 0.3 percent against the yen at 162.08 yen EURJPY=.

The yen tends to weaken when stock prices are rising, as a buoyant equity market usually reflects higher investor appetite for risk. One of their favorite strategies has been borrowing cheap in yen to finance purchases of high-yielding currencies like the New Zealand dollar in so-called carry trades.

Also on Friday, the fed funds rate rose as high as 6 percent -- well above the Fed's target of 5.25 percent -- prompting the central bank to inject temporary reserves into the banking system.

Overnight interest rates in the euro zone and United States have spiked in recent days as financial institutions scramble to hold extra liquidity due to turmoil in the credit markets.

The dollar, which hit a 15-year low against a basket of major currencies earlier in the month, has posted modest gains this week as volatility in global financial markets has led some investors to seek the safety of dollar deposits.

"In times of crisis, the dollar is still the premier currency," said Peter Dunay, investment strategist at Leeb Capital Management in New York.

The woes in the credit market have also led the market to fully price in a quarter-percentage-point Fed rate cut by September. Traders are also betting on a less than 50/50 chance that the European Central Bank will raise interest rates next month, down from a 70 percent chance at the beginning of this week. They have drastically scaled back expectations that the Bank of Japan will tighten monetary policy this month, to a chance of one in three from around 75 percent previously.