By Steven C. Johnson
NEW YORK, Dec 18 (Reuters) - The dollar gained on the yen on Tuesday as traders covered their bets against the greenback and began taking profits ahead of year end.
Volumes were thin as investors began closing the books on 2007, leading to jittery trading influenced heavily by technical factors and flows, traders said.
The European Central Bank's extension of $500 billion in two-week loans to euro-zone banks also helped ease anxiety about a year-end credit squeeze, traders said, prompting some investors to wade back into yen-funded carry trades.
"The ECB provided a bit of systematic relief, and that's led to some renewal of risk-taking activity," said Robert Fullem, vice president of corporate foreign exchange sales at The Bank of Tokyo-Mitsubishi-UFJ in New York.
"But it is a very thin market out there, and the few orders that are out there are keeping currencies in ranges," he said.
Investors have long borrowed yen at low Japanese rates to fund purchases of higher-yielding currencies and assets. As a result, the yen's fortunes wax and wane in inverse proportion to market risk appetite.
Late afternoon, the dollar was up half a percent at 113.38 yen <JPY=>, near its session peak of 113.52 yen. The euro also rose 0.5 percent to 163.35 yen <EURJPY=>.
The euro traded at $1.4403 <EUR=>, little changed from late Monday, while sterling fell 0.5 percent at $2.0121 <GBP=>.
Analysts said the ECB's massive injection bolstered the argument of dollar strength against the euro into year end.
"There is talk that some foreign banks (e.g. U.S. and UK) may have taken in funds as well and at lower rates than they can secure from their respective markets," wrote Win Thin, currency strategist at Brown Brothers Harriman in New York, in a note to clients.
"This may lead to some euro sales as the borrowings are converted and/or hedged. The foreign exchange implications of these money market operations are on the margin, but maybe part of the firmer dollar story that many will overlook," he said.
Investors are also awaiting Wednesday's results of this week's liquidity injection plans by top central banks.
The dollar has benefited over the past week from unexpectedly strong U.S. retail sales and inflation data, which fanned speculation that the Federal Reserve may be less aggressive in cutting interest rates next year.
However, the latest Reuters poll still shows a 40 percent chance of a U.S. recession next year.
The Fed is expected to cut its benchmark overnight lending rate twice by 25 basis points to 3.75 percent in the first half of 2008 and leave monetary policy unchanged for the rest of the year, the poll showed. For details, see USKEY1.
Adam Hewison, president of INO.com, an information service for traders in Shady Side, Maryland, said the dollar looks poised to continue rallying in early 2008 after falling sharply against most major currencies this year.
"We have seen a fairly healthy correction here. I think we're going to see much more two-way trading in the first and second quarters of 2008," he said.
If interest rates stabilize, he said traders will be pushed to cover dollar shorts, setting the euro up for a test of $1.40 and sending the dollar back into the 118-120 yen range in the first half of the year.
"Bears often make the best bulls and they will have to cover their short positions sometime," he said. (Additional reporting by Lucia Mutikani; Editing by Jonathan Oatis)