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NEW YORK, Aug 29 (Reuters) - The yen suffered its biggest one-day percentage decline against the euro in more than three years and the dollar in more than two years on Wednesday, as investors took recovering U.S. stock markets as a cue to slash short-term bets that the Japanese currency would strengthen.
Foreign exchange dealers have been using global equity markets as a gauge of risk appetite, particularly because the tightening credit market has lifted volatility and dented the carry trade, in which investors borrow cheaply in currencies such as yen to buy higher-yielding, riskier assets.
"We are having a correction in the yen as speculative players riding long yen positions take profits and wait for a more advantageous entry position," said Michael Woolfolk, senior currency strategist at The Bank of New York Mellon.
The yen had climbed sharply on Tuesday, in tandem with tumbling global stocks, as traders cut back carry trade bets on greater apprehension of the fallout from the U.S. subprime mortgage meltdown.
However, on Wednesday, the dollar rose 1.7 percent to 116.12 yen <JPY=>, rebounding from a one-week low of 113.88 earlier in the session, as U.S. stock indexes climbed after falling more than 2 percent on Tuesday.
At current prices, the dollar was on pace for the biggest daily percentage gain against the yen since January 2005, according to Reuters data.
The euro climbed 2.2 percent to 158.78 yen <EURJPY=>, and also rose 0.5 percent against the dollar to $1.3671 <EUR=>.
The euro's gain on the yen so far on the day was the biggest since March 2004, at current prices according to Reuters data.
Sterling climbed 0.8 percent to $2.0174 <GBP=>.
CAUTION, VOLATILITY AHEAD
Soft data from the U.S. housing and consumer sectors and news of more financial institutions being affected by troubles in the U.S. subprime mortgage sector led to a broad sell-off in risky assets earlier in the week.
But on Wednesday investors cashed in on the yen's two-day rally, heartened by the solid rise in Wall Street stocks, despite more signs of difficult credit conditions in short-term money markets.
Caution was still the word on most analysts' lips, particularly as dealers wondered whether tough lending conditions would prompt easing in the Federal Reserve's monetary policy.
"The overlaying glacier that is the credit crunch has not gone away," said Joe Francomano, vice president of foreign exchange at Erste Bank in New York.
U.S. economic growth data on Thursday and inflation figures on Friday could give investors a clearer picture on how the recent market turbulence might have affected the real economy, ahead of the keenly watched payrolls report the following week.
Speculation is rising that the Fed might cut the benchmark federal funds rate from 5.25 percent at its next meeting in September, although the central bank maintained its focus on inflationary risks in its August minutes.
How Fed Chairman Ben Bernanke characterizes the surge in financial market volatility of the last month in a speech on Friday could very well determine the outlook for risk taking.
"Bernanke's speech is all the more important because it will be forward-looking," said The Bank of New York Mellon's Woolfolk.