The yen hit a 14-year high versus the dollar and rallied broadly on Friday, while the dollar jumped against most other currencies as investors cut carry trades and risk exposure on concern about Dubai's debt problems.
By mid-session in London, however, exchange rates had recovered some ground and were trading in narrower ranges, while volatility had eased.
Earlier, Japan signalled growing discomfort with the yen's surge -- it briefly broke the 85 yen per dollar level -- and suggested it would be open to a Group of Seven joint statement on currencies to cool the rally.
Market sources said the Bank of Japan checked exchange rates earlier in Asian trading with Japanese commercial banks, raising fears of outright intervention, although analysts say this is unlikely right now.
But the speed and scale of dollar/yen's fall was such that a recovery was always likely, particularly after Japan's Finance Minister Hirohisa Fujii said the moves were extreme and it was possible Japan could respond.
The sharp declines in other markets were also reversed or pared back by mid-session in London. European banking stocks were up half a percent on the day, having fallen at the open .SX7P.
French banks said they had limited exposure to the Dubai debt crisis and Bank of Italy Director General Fabrizio Saccomanni said Italian banks had very limited exposure.
Dubai struggled to ease fears of debt default on Thursday after its move to delay repayments at two flagship firms shook confidence in the Middle East and raised the prospect of further huge debt write-offs for banks.
The market is taking a breather. Volatility had soared in early hours after the risk trade headed for the exits in thinned liquidity, said Jane Foley, chief strategist at FOREX.com.
It is likely to take at least a few days before the implications of the impact of a possible default from Dubai are properly digested but for the present it seems that the market is seeing this negative news as a blow to the global recovery but not one that will push it off course, she said.
JAPAN IN SPOTLIGHT
The dollar fell as far as 84.82 yen JPY=, its weakest since 1995 and ever closer to its record low of 79.75, before pulling back up to 86.50 yen at 1200 GMT, flat on the day.
At 1230 GMT the dollar index, a measure of its value against six major currencies, was up 0.6 percent at 75.29 .DXY, having been up around 1 percent earlier.
The euro was down 0.75 percent at $1.4900 EUR=, having earlier slid as low as $1.4830 EUR=, more then three cents down from a 15-month high of $1.5144 reached on Wednesday.
Other assets were also hit before regaining some ground: U.S. stock futures showed Wall Street opening down 2.5 percent, oil was down 4.5 percent CLc1, and gold XAU= and silver XAG= lost 3 and 4 percent, respectively.
FX markets are nervous as Dubai debt contagion fears fuelled a flight to quality bid, which favoured the dollar. The yen benefited via the crosses, but FX intervention risk rose significantly overnight, said Russell Bloom, analyst at Action Economics in London.
But early liquidation of speculative positions has been absorbed by those placing their faith in BoJ action, he said.
Implied volatilities on one-week euro/dollar currency options EURSWO= rose to 13 percent earlier, a high not seen since June.
One-week implied volatilities on dollar/yen options surged above 18 percent JPYSWO= for the first time since April, sharply up from a 2009 low of 5 percent earlier this week.
Japanese Finance Minister Hirohisa Fujii raised the prospect of a G7 joint statement on currencies and said a government response to extreme moves was possible.
While some analysts said the G7, or the bigger G20, could issue a statement to prevent the dollar from weakening further, or Japan could step in alone, others doubted the chance of joint intervention above 80 yen.