LONDON, Feb 23 (Reuters) The yen rose one per cent against the dollar and euro on Thursday after the Bank of Japan hinted it would eventually raise interest rates from the current near-zero levels, denting the dollar's yield advantage.
The euro rose a third of a U.S. cent after Germany's closely-watched Ifo business sentiment index hit its highest level in more than 14 years in February, underlining the euro zone's recovery and cementing expectations for a interest rate hike next week.
Speaking in parliament, BOJ Governor Toshihiko Fukui suggested the central bank's five-year-old policy of flooding the financial system with money would end soon, adding that it would raise rates to a ''neutral'' level at some point.
''There is a strong focus on interest rates. Rates have been so low in Japan and with the U.S. raising rates, the negative spread has been increasing,'' said Johan Javeus, currency strategist at SEB in Stockholm.
''But we got a clear signal the BOJ would remove monetary policy stimulus. The market expects this to happen after the end of the fiscal year and it seized on this.'' By 1230 GMT (1800 IST) the dollar fell as low as 116.94 yen, a one-week low and down more than one per cent on the day.
The euro also hit a one-week low of 139.55 yen.
Analysts say the yen was also bolstered as investors unwound carry trades with general sentiment towards high-yielding currencies bruised after sharp falls in the New Zealand dollar and Icelandic crown this week.
''To me this is market nervousness over carry trades ...
obviously with the yen as the favoured funding currency, it's coming back on the back of the unwind of these positions,'' said Derek Halpenny, currency economist at Bank of Tokyo Mitsubishi.
The euro was up 0.4 per cent at .1955, having been trapped within a broad range of .18-1.23 since mid-December.
IFO UP The Ifo climate index rose to 103.3 in February from an upwardly revised 101.8 in January, the third rise in succession, taking the index to its highest level since October 1991.
''A broader based recovery is underpinning optimism, with stronger exports, more robust investment intentions and stronger domestic demand adding to the improved business mood,'' said David Brown, chief European economist at Bear Stearns.
''It looks like a quarter point ECB rate hike should be in the bag next week.'' Consumer price data from North Rhine-Westphalia in Germany suggested however that the annual rate of German inflation probably remained broadly stable in February.
The Swedish central bank raised interest rates by 25 basis points to 2 per cent earlier on Thursday but the crown fell to a seven-week low against the euro as the Riksbank said the pace of future rate hikes might slow.
Several Federal Reserve officials -- although non-voting members -- are due to speak later on Thursday, including Dallas Fed's Richard Fisher.
The Fed is widely expected to boost overnight rates to 4.75 per cent in March from the current 4.5 per cent, with more market players forecasting the rate to climb to 5 per cent by mid-year.
Goldman Sachs said with interest spreads set to narrow between Japan and the United States, correlation between Japan and the rest of the developed world might increase.
''Japanese markets may become more synchronous with foreign ones. One of the costs to Japan of no longer doing its own thing, as it were, may therefore come in the form of a lower international diversification value of its financial assets,'' Goldman said in a note to clients.
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