Sept. 16 (Bloomberg) -- The yen touched a two-year high against the euro as the debt-rating downgrade of American International Group Inc. fueled concern credit markets are seizing up after the collapse of Lehman Brothers Holdings Inc.

Japan's currency reached the highest level in almost five years against the New Zealand dollar on speculation investors will reduce holdings of higher-yielding assets and pay back loans in the yen. The dollar rose versus the euro as traders forecast the Federal Reserve will cut interest rates at its meeting today and investors sought a haven.

``The markets are turning upside down,'' said Samarjit Shankar, director of global strategy for the market group in Boston at Bank of New York Mellon, the world's largest custodial bank, with more than $23 trillion in assets. ``Nobody knows what's coming next in terms of news flow. Institutional investors are getting out of risky positions and parking their money in short-term bills denominated in the yen.''

The yen traded at 149.01 per euro at 1:24 p.m. in New York, compared with 149.11 yesterday. It touched 147.04, the strongest since August 2006. Japan's currency fell 0.7 percent to 105.35 per dollar, from 104.66, after touching 103.54, the strongest since May 27. The dollar increased 0.7 percent to $1.4144 per euro, from $1.4243 yesterday, when it reached $1.4481, the weakest level since Sept. 4.

Japan's currency erased its gain versus the dollar and pared its advance against the euro as financial network CNBC reported that U.S. ``assistance'' to AIG is a possibility.

AIG Downgrade

AIG's credit was downgraded by Standard & Poor's and Moody's Investors Service, threatening efforts to raise emergency funds to keep the company afloat. The largest U.S. insurer by assets is seeking $70 billion to $75 billion in loans arranged by Goldman Sachs Group Inc. and JPMorgan Chase & Co., according to people familiar with the situation.

Lehman filed for the biggest bankruptcy in history yesterday after Bank of America Corp. and Barclays Plc pulled out of talks to buy the New York-based firm.

Money-market rates surged today as lending between banks all but seized up. The London interbank offered rate, or Libor, for overnight dollars more than doubled to the highest level in seven years, the British Bankers' Association said.

The dollar may fall to 101.45 yen after it dropped below support of 104.95, wrote Andrew Chaveriat, a technical analyst at BNP Paribas SA in New York, in a research note yesterday. A support level is where buy orders cluster.

Support at 104.95 yen is a 38.2 percent retracement of the dollar's climb from the March low of 95.76 yen to the August high of 110.66 yen, based on a series of numbers known as a Fibonacci sequence, Chaveriat wrote.

Yen Shorts

The dollar may fall further against the yen as investors cover short positions against Japan's currency, according to Robert Blake, a strategist in Boston at State Street Global Markets LLC, which has $15.3 trillion in assets under custody.

``Our flow data suggest sophisticated institutional investors remain short on the yen,'' Blake said. ``I would be hesitant to put a bottom on the dollar-yen.'' A short position is a bet a currency will decline.

The yen gained as much as 2.5 percent to 67.25 against the New Zealand dollar, the strongest level since November 2003, and 3.5 percent to 81.43 versus the Aussie on bets investors reduced carry trades, in which they borrow where interest rates are low and buy higher-yielding assets elsewhere. Japan's 0.5 percent target lending rate compares with 4.25 percent in Europe, 7 percent in Australia and 7.5 percent in New Zealand.

The Standard & Poor's 500 Index rose 0.3 percent after posting the steepest drop since September 2001 yesterday.

Fed Cash

The Fed added $50 billion in temporary reserves to the banking system after injecting $70 billion yesterday, the most since the Sept. 11, 2001, terrorist attacks. The European Central Bank offered 70 billion euros ($99.8 billion) in a one- day money-market auction today.

The Libor OIS spread, which measures the availability of funds in the market, increased 15 basis points, or 0.15 percentage point, to 120 basis points today, the widest since at least December 2001.

Futures on the Chicago Board of Trade showed a 100 percent chance the Fed would reduce the target rate for overnight lending by a quarter-percentage point. Traders saw a 2 percent chance of a rate cut a week ago.

``The market is expecting the Fed to calm things down,'' said Henry Wilkes, head of foreign-exchange trading at Brown Brothers Harriman & Co. in London. ``Whether they actually will is another matter. We're heading into unprecedented waters with the concerns about AIG and the contagion into the insurance market. A lot of people are a bit shell-shocked.''

Implied volatility on one-month euro-dollar options reached 14.71 percent today, the highest level since the aftermath of the Sept. 11 attacks, indicating traders see more price fluctuation in the next month. Volatility on one-month dollar- yen options touched 18.79 percent, the highest since March 17, the day before the Fed cut borrowing costs.

To contact the reporters on this story: Ye Xie in New York at yxie6@bloomberg.net; Bo Nielsen in Copenhagen at bnielsen4@bloomberg.net

Last Updated: September 16, 2008 13:31 EDT