(Changes byline, updates prices, adds quotes)
By Toni Vorobyova
LONDON, July 27 (Reuters) - High yielding currencies fell sharply in volatile markets on Friday as an overnight sell-off in credit and stock markets led investors to pare risky carry trades.
The rise in risk aversion originally sent the low-yielding yen to a three-month high against the dollar and a six-week high versus the euro. But the Japanese currency's gains proved short-lived, in part due to soft retail sales data from Japan and also because of a recovery in European stock markets.
The S&P 500 shed about $300 billion in market value in the worst single session since February overnight and Japan's Nikkei average dropped to a 3-month low. But European shares reversed earlier losses, with FTSEurofirst trading 0.4 percent higher.
"Markets are very nervous on all fronts - equities, bonds and currencies ... It is Friday and it's the end of the month, so we can have a very nervous market ahead of the weekend," said Niels Christensen, FX strategist at Nordea.
"(But) it's a two-way business. Some might be closing down their carry trades, while others see this as an opportunity to go in at very attractive levels. That's the reason why the yen is a bit weaker."
The Australian dollar tumbled as much as 1.25 percent versus the U.S. dollar <AUD=> and the New Zealand dollar also fell <NZD=> in a sharp retreat from 18 and 22 year peaks, respectively, set earlier this month.
Sterling, another high yielder, was down 0.5 percent to $2.0376 <GBP=> at 0922 GMT, well off the $2.0655 26-year peak hit on Tuesday.
The euro was down 0.6 percent at $1.3660 off a $1.3852 record hit earlier in the week <EUR=> according to Reuters data.
RISK AVERSION AT 6-YEAR HIGH
The UBS Risk Index which measures risk averse behaviour was at its highest level since September 2001, the month of the 9/11 attacks on U.S. cities. Analysts said the current environment was leading investors to safe haven assets.
"Equities are down, credit is wider, volatility is wider, swap spreads are wider so the whole picture is taking shape of the classical flight to quality move," said Jean-Francois Robin, strategist at Natixis in Paris.
The yen rose to a three-month high of 118.18 per dollar <JPY=> before retreating to 119.20. It set a 1-1/2 month high of 162.40 per euro before retreating to 162.87 <EURJPY=>.
Japanese retail sales fell 0.4 percent in June from a year earlier, government data showed on Friday, falling short of economists' median forecast for a 0.6 percent increase.
Another factor weighing on the yen was Sunday's election for half the seats in the upper house of Japan's parliament. The ruling Liberal Democratic Party is seen faring poorly due to funding scandals and voter anger over lost pension records.
"Should the LDP lose by a greater-than-expected margin, prime minister (Shinzo) Abe may be forced to step down and the resulting political uncertainties could bolster expectations for the BoJ to postpone rate hikes at the Aug. 22-23 meeting. This would be bearish for the yen," JP Morgan said in a client note.
U.S. second quarter gross domestic product growth data are due later in the session. The median forecast in a Reuters survey is for growth to rebound to 3.2 percent after braking sharply to 0.7 percent in the first quarter.