(Adds details, updates prices)
By Lucia Mutikani
NEW YORK, Oct 22 (Reuters) - The dollar rebounded from all-time lows on Monday as investors covered short positions on views that the currency's recent fall might be overdone and investors pulled back from risky bets.
The dollar hit record lows against the euro and a basket of major currencies in overseas trade, but reversed course as growing risk aversion also encouraged further unwinding of yen-funded carry trades, where investors borrow a low yielding currency to buy a higher yielding one.
"We are seeing a lot of liquidation of cross trades and carry trades. The cross traders are a dominant force here," said Shaun Osborne, senior currency strategist at TD Securities in Toronto.
In late New York trade, the euro was down 0.9 percent on the day at $1.4170 <EUR=>, having traded at a new lifetime high of $1.4348 earlier in the day, according to Reuters data, and as low as $1.4126, a spread of more than two cents on the day.
The euro posted its biggest one-day decline against the dollar since July 2006.
"We have got a very powerful downward day in euro/dollar today. This could well put a cap on euro/dollar in the medium term, but it wouldn't necessarily mean that we would trade too much lower," said Osborne.
The dollar index, which tracks the greenback's value against six major currencies, reclaimed the 78 level and last traded 1.1 percent higher at 78.002 (.DXY: Quote, Profile, Research). The index rebounded from a post-Bretton Woods low of 77.093 struck earlier, registering its largest daily spike since early January.
"It's all part of a broader risk reduction. The euro got caught up in that. I am not saying that dollar is being bought as a safe haven. Euro/yen saw a sharp selling and when euro/yen gets really hit hard, euro/dollar tends to follow suit," said Richard Franulovich, strategist at Westpac in New York.
Investors sold the U.S. currency early in the global session, disappointed that the statement from G7 finance ministers and central bankers at the weekend made no specific mention of the dollar's recent weakness.
RISK AVERSION BUOYS YEN
The euro fell 1 percent against the yen to 162.07 yen <EURJPY=>, well off last week's 2-1/2 month peak of 167.72 yen, while the dollar was off 0.1 percent against the Japanese currency at 114.38 yen <JPY=>.
But the greenback rose against the Canadian and Australian dollars. Rising risk aversion among investors pushed the yen sharply higher across the board.
The U.S. currency gained 1.3 percent against the Canadian dollar to C$0.9788 <CAD=>, while the Australian dollar slipped 0.5 percent to $0.8865 <AUD=>.
Some of the Canadian dollar's drop was attributed to remarks by Bank of Canada Governor David Dodge on Sunday, suggesting its advance against the greenback was speculative and not strictly linked to the economy or weak U.S. dollar.
Sterling dropped 1 percent to $2.0322 <GBP=>.
The dollar's recovery versus the euro raised the specter of further gains in the near-term, but analysts said much would depend on the equity markets and investors' attitude toward risk.
"A lot will be decided over the course of this week. We need to see equity markets remain relatively soft and continued risk aversion to see the dollar do much better from here," said TD Securities' Osborne.
U.S. stocks recouped earlier losses, which were triggered by falls in European equity markets.
While analysts expected the euro to decline towards $1.40 and possibly test $1.3850, prospects for more rate cuts by the Federal Reserve to shield the economy from a housing market slowdown would likely force the dollar to resume its slide.
"Ultimately the interest rate differential will keep pushing in the euro's favor," said Westpac's Franulovich.
U.S. interest rate futures were pricing in a roughly 84 percent chance of a 25-basis-point rate cut at the Fed's Oct. 31 monetary policy meeting.