* Dollar drops to lowest since Japan intervened last week
* Dollar index drops to lowest in six months
* Euro at five-mth high, Swiss franc at 2-1/2 year peak
(Updates prices; adds quote)
By Anirban Nag
LONDON, Sept 22 (Reuters) - The dollar fell on Wednesday to its lowest level versus the yen since Japan intervened last week, with the dollar index hitting a six-month trough after the Federal Reserve raised expectations of more monetary easing.
The euro EUR= vaulted option barriers at $1.3350 to a five-month high of $1.3392 on electronic trading system EBS as investors including a large U.S. investment bank sold the greenback and piled into the single currency.
But the market was wary about selling the dollar against the yen too aggressively, anxious it might trigger another wave of intervention by the Japanese authorities that wrong-footed many investors, including hedge funds, last week.
"The Fed has lowered the bar for more quantitative easing and the market is just following the path of least resistance in selling the dollar," said Paul Mackel, director of currency strategy at HSBC Markets.
"Having said that, sellers of dollar/yen will have to be very nimble as intervention risks are very high. We would expect the Japanese to intervene once the price action gets too one-sided."
By 0945 GMT, the dollar was down 0.6 percent against the yen at 84.55, well off last week's high of 85.94 yen JPY=. It fell as far as 84.53 yen, still more than two yen above a 15-year low of 82.87 set last Wednesday just before Japanese authorities intervened to send it three yen higher in a day.
Many traders expect Japan to step in between 83.00 and 85.00 yen. They said the authorities had called banks to ask if they will be staffed on Thursday, a Japanese national holiday, in an apparent attempt to keep traders cautious over intervention.
"I think they will intervene if the dollar falls to 84 yen or below," said Tom Levinson, FX strategist at ING. "Dollar/yen is pretty sensitive to the fall in U.S. yields, so it looks like pressure will be back on the Japanese authorities to intervene."
Last week, Japan intervened minutes after the dollar fell below 83 yen, its first intervention since 2004.
For a PDF on the yen click: r.reuters.com/fac44p
Japanese Prime Minister Naoto Kan kept investors nervous by telling the Financial Times intervention was 'unavoidable' if there was drastic change in the currency. [ID:nLDE68K2AL]
RACE TO THE BOTTOM
The dollar index .DXY=USD, a measure of its performance against a basket of six currencies, fell 0.8 percent to 79.786 its lowest since mid-March.
The drop in the index came after the Fed expressed greater concern about sluggish U.S. growth and low levels of inflation in a statement that many took as opening the door wider to pumping more dollars into the economy. [ID:nTRU002490]
A fall in U.S. Treasury yields compounded the dollar's problems, with short-dated yields at record lows after the Fed statement, making U.S. debt less attractive to Japanese investors. [US/].
"A break below the key 79.50-80 region appears to be just a matter of time," Robert Rennie, chief currency strategist at Westpac said in a note. "The coming weeks will be very challenging for the U.S. dollar."
The euro rose 1 percent versus the dollar after climbing 1.5 percent on Tuesday, helped by buying by Middle East central banks, traders said. It firmed past its 200-day moving average on Tuesday, pointing to more gains on the charts.
"It is pretty much a one-way trade going on now," added ING's Levinson. "Investors are funding euro positions by selling the dollar. Also, this week the debt auctions went pretty well, so that's a boost to the euro."
Portugal's sale of bonds saw strong demand on Wednesday [ID:nLIS002462], just a day after investors lapped up debt issuance from Greece, Spain and Ireland.
The dollar also fell against the Swiss franc CHF=, dropping to 0.9899 francs, its lowest since April 2008.