By David McMahon
NEW YORK, July 26 (Reuters) - The yen surged on Thursday, climbing to a three-month high against the dollar, as investors spooked by growing problems in credit markets fled risky assets financed by borrowing in the low-yielding Japanese currency.
Credit spreads widened, stocks fell sharply, and U.S. benchmark Treasury yields tumbled in a flight to quality that prompted currency traders to buy back yen that had been used to buy higher-yielding currencies like sterling in carry trades.
"It's clearly a case of the tail wagging the dog in the FX markets today," said Robert Sinche, global head of currency strategy at Bank of America in New York. "We're seeing a big rise in risk aversion and unwinding of positions in other markets, and that is hurting the carry trade."
The spillover to the currency market got even uglier after the dollar tumbled below its 200-day moving average against the yen <JPY=>, a long-term technical chart signal, triggering a wave of automatic orders to sell dollars and buy yen, dealers said.
By late afternoon, the dollar was down 1.4 percent at 118.70 yen, on track for its biggest daily decline against the Japanese currency in around 5 months.
Amid mounting fears that the U.S. housing market is deteriorating and worries that financing of corporate takeovers is becoming more difficult, the Dow Jones industrial average (.DJI: Quote, Profile, Research) was also on track for its worst day in five months.
U.S. and European junk bonds took a beating, while the 2-year Treasury yield <US2YT=RR> dropped 18 basis points, headed for its biggest daily fall in around three years. Analysts said that until stock and bond markets settled, currency traders would likely keep buying back yen and reducing their exposure to riskier high yielding currencies.
The euro slid 1.3 percent to 163.20 yen <EURJPY=> after dropping to 162.90 yen earlier in the session, the lowest in more than a month.
The yen's gains were most pronounced against the New Zealand dollar, which boasts the world's highest interest rates and is a darling of Japanese investors, but was dealt a blow earlier in the day after the Reserve Bank of New Zealand said that it may have raised rates enough to cool inflation.
The kiwi fell 3.4 percent against the yen, the biggest decline since late February, to 93.10 yen <NZDJPY=R>.
Meanwhile the euro <EUR=> rose 0.1 percent to $1.3740, just over one cent below a record high hit earlier in the week.
The Swiss franc, another popular funding currency for carry trades, also rallied sharply. The U.S. dollar fell 0.8 percent to 1.2035 francs <CHF=>.
Dealing another blow to the dollar, U.S. new home sales fell unexpectedly sharply in June and prices slumped, according to a government reports on Thursday that pointed to continuing weakness in the housing sector. For details, see [ID:nN2614904]
"It's bad news all around for the dollar," said David Powell, senior currency strategist with IDEAglobal in New York. "That doesn't bode well for the category of GDP that's been a drag for so long, residential fixed construction."
The U.S. government will release its first reading of gross domestic product in the second quarter on Friday, which is expected to show a solid rebound from the first quarter, when the economy grew at the slowest pace in more than four years.
The U.S. economy grew 3.2 percent in April-June, compared to 0.7 percent in the previous quarter, according to the median forecast of a Reuters poll. (Additional reporting by Kevin Plumberg)