* N Korea tensions, China downgrade weigh on risk sentiment
* Dollar bolstered by Fed’s signal that hike is possible this year
* German elections not seen as risk event for euro
* Graphic: World FX rates in 2017 tmsnrt.rs/2egbfVh
By Jemima Kelly
LONDON, Sept 22 (Reuters) - The dollar buckled against the yen on Friday as tensions simmered on the Korean peninsula, though the sharp divergence between U.S. and Japanese monetary policy kept the greenback on track for a winning week against the yen.
North Korea said on Friday it might test a hydrogen bomb over the Pacific Ocean after U.S. President Donald Trump threatened to destroy the reclusive country, with leader Kim Jong Un promising to make a “mentally deranged” Trump pay dearly for his comments.
The dollar dropped as much as 0.8 percent to 111.65 yen in Asian trade, before recovering to trade down around 0.4 percent at 112 yen as traders arrived at their desks in New York.
The yen tends to benefit during times of crisis due to Japan’s net creditor nation status, and the expectation that Japanese investors would repatriate assets.
For the week, the dollar was still up more than 1 percent against the yen, having scaled a two-month peak of 112.725 after the U.S. Federal Reserve signalled that it was still on track to raise interest rates by the end of the year, and after the Bank of Japan maintained its bond-buying pledge.
“Threats of an H-bomb test in the Pacific Ocean from North Korea brought an usual knee-jerk reaction across markets overnight,” said Saxo Bank’s head of currency strategy, John Hardy, in London.
“The U.S. dollar rally on the back of Wednesday’s Federal Open Market Committee meeting entirely failed to follow through, and euro/dollar and sterling/dollar have erased most of the downside, keeping patient dollar bears in business,” he added.
The dollar index, which tracks the U.S. unit against a basket of six major rivals, fell 0.3 percent to 92.024, but it was still slightly higher on the week and was well above its more than 2-1/2 year trough of 91.011 marked on Sept. 8.
It surged to its strongest in 15 days on Wednesday, but has since slipped around 1 percent.
“Even if the Federal Reserve were able to deliver on a December rate rise, there is so much uncertainty about what the FOMC will look like in six months’ time... that any projections for three further rate rises in 2018 have to be treated with a huge amount of caution,” said CMC Markets analyst Michael Hewson.
The euro inched up 0.2 percent to $1.1962, with traders not seeing Sunday’s German elections as a risk. Chancellor Angela Merkel is widely expected to win a fourth term in power.
Sterling was treading water against the dollar, with a key speech on Brexit by Prime Minister Theresa May later in the day in focus for traders. (Reporting by Jemima Kelly; Additional reporting by Lisa Twaronite; editing by Gareth Jones)