The dollar edged higher across the board on Wednesday as investors awaited signals from the Federal Reserve on further interest rate hikes which may accompany a rise widely anticipated for later this week.
The Federal Open Market Committee (FOMC) is expected to lift overnight rates for a 17th straight policy meeting on Thursday to 5.25 percent from 5 percent, but the focus is on what the central bank signals about its next meeting in August.
Expectations for higher interest rates in the United States and elsewhere have triggered massive unwinding of carry trades or investment in emerging market assets in recent weeks.
It has also raised concerns about the negative impact on economic growth from tightening.
The market is reluctant to seek new positions ahead of the FOMC. We know they would raise rates but the market wants to see what kind of balance they would strike, said Daragh Maher, currency strategist at Calyon.
We've seen a pick-up in core inflation and expectations for a moderation in growth. If one overshadows the other it will give an indication for August (rate decision).
By 1130 GMT, the dollar stood at 116.22 yen, after hitting a two-month high on Tuesday at 116.70. The euro was down 0.2 percent at $1.2560 and down versus the yen at 146.03 yen.
The single currency climbed as high as 146.65 yen on Tuesday -- its strongest since it was launched in 1999.
The Swiss franc hit the day's high against the euro after the closely-watched Swiss KOF leading indicator of business sentiment came in higher-than-expected, underpinning expectations for higher Swiss interest rates.
European Central Bank officials also kept up their hawkish rhetoric on fighting price pressures on Wednesday.
Governing Council member Nicholas Garganas said further interest rate increases are expected. Axel Weber was quoted as saying the ECB was ready to act swiftly to counter inflationary risks.
They have been hawkish but it does seem there has been a step-up in the level, Maher said.
Investors are betting that the ECB will step up the pace of monetary tightening after policymakers' comments and surprisingly strong confidence data.
Money markets are pricing in a 50 percent chance that the ECB will raise interest rates at its August 3 meeting, having priced in only a 20 percent chance two weeks ago. However, analysts saw only a 30 percent chance of this, according to a Reuters poll released on Wednesday.
The ECB has raised borrowing costs three times since December, bringing them to 2.75 percent earlier this month.
Investors will watch for more hawkish comments from ECB Governing Council member Yves Mersch, who is due to speak on monetary policy at 1400 GMT. Mersch said this week the ECB has not ruled out more aggressive credit tightening.
At its last meeting in May, the Fed said that some further policy tightening may yet be needed to stem inflationary pressures but such action would depend on the economic outlook.
In recent weeks Fed officials have expressed worries that inflation has heated up too much, stoking expectations for another rate increase in August to 5.5 percent that would help the dollar maintain its yield advantage.
Elsewhere, the New Zealand dollar fell to a two-year low of US$0.5945 after New Zealand unexpectedly posted a trade deficit for the first time in three months in May.
With transition to a softer global demand environment an almost explicit central bank objective, the outlook for commodity linked currencies is fraught with risk, HBOS Treasury Services said in a note to clients.