Dec. 20 (Bloomberg) -- The yen may extend its gains against the euro and pound as speculation increased that subprime mortgage losses will slow economic growth, damping investors' appetite for higher-yielding assets funded by loans in Japan.

Japan's currency rose yesterday as the credit outlooks of MBIA Inc. and Ambac Financial Group Inc., the world's largest bond insurers, were lowered to negative by Standard & Poor's. The Bank of Japan will keep the lowest borrowing costs among industrialized nations unchanged today, according to all of the 44 economists surveyed by Bloomberg News.

``I favor the yen to strengthen on risk aversion,'' said Brian Dolan, chief currency strategist at FOREX.com, a unit of online currency trading firm Gain Capital in Bedminster, New Jersey. ``The risk environment and uncertainty got a whole lot worse.''

The yen traded at 163.12 per euro at 7 a.m. in Tokyo after advancing 0.3 percent yesterday. Japan's currency traded at 226.61 per pound after increasing 0.8 percent, and 113.42 per dollar after touching 112.75 yesterday. The U.S. currency traded at $1.4385 per euro after touching $1.4326 yesterday, the strongest since Oct. 26. The pound traded at $1.9979 after falling below $2 for the first time in three months yesterday.

The Bank of Japan will probably refrain from raising its target lending rate from 0.5 percent today after a drop in business confidence signaled companies are bracing for slower economic growth.

Fukui on Expansion

Weak profits at small companies could hamper wage growth and consumer spending, Governor Toshihiko Fukui of the central bank said this month. He acknowledged that the benefits of Japan's corporate-led expansion aren't flowing to households as quickly as he had anticipated.

The yen rose 0.5 percent versus the South African rand and 0.1 percent against the Australian dollar yesterday on speculation that subprime mortgage losses discouraged carry- trade investors from borrowing in Japan and buying higher- yielding assets elsewhere.

In carry trades, investors get funds in a country with low borrowing costs and buy assets where rates are higher, earning the difference. The risk is that exchange-rate swings may erode gains from yield differentials.

Compared with Japan's target lending rate, benchmark borrowing costs are 11 percent in South Africa, 6.75 percent in Australia and 5.5 percent in the U.K.

S&P yesterday also cut the rating of bond insurer ACA Financial Guaranty Corp. to CCC, a level that suggests potential default, and placed Financial Guaranty Insurance Co.'s AAA rating under review for a possible downgrade.

Morgan Stanley

Morgan Stanley, the second-largest U.S. securities firm, yesterday wrote down its subprime-infected mortgage holdings by a greater-than-expected $9.4 billion and received a $5 billion cash infusion from China Investment Corp. The state-run fund will acquire as much as 9.9 percent of the firm.

``It will take time to weed out the subprime and credit issues,'' said Jeff Gladstein, global head of foreign-exchange trading in Wilton, Connecticut, at AIG Financial Products. ``We are going to muddle through the first quarter.''

Japan's currency pared gains against the dollar yesterday after the Federal Reserve, European Central Bank and Swiss National Bank loaned $34 billion in 28-day funds through special auctions to restore faith in the money markets.

The Fed auctioned $20 billion in loans at an interest rate of 4.65 percent, less than the 4.75 percent the U.S. central bank charges financial institutions to borrow directly at its discount window, suggesting banks weren't desperate for funds.

`Short-Term Comfort'

``It provides some short-term comfort to investors as the Fed suggested it's willing to stay active to help ease the money-market squeeze,'' said Mark Meadows, a trader in Washington at currency-trading firm Tempus Consulting Inc. ``I don't think this will solve the longer-term problem in growth.''

Central banks are seeking to revive inter-bank lending after financial institutions reported more than $70 billion of losses linked to subprime mortgages this year. The ECB injected an unprecedented $500 billion into the banking system this week to ease gridlock in money markets.

To contact the reporters on this story: Min Zeng in New York at mzeng2@bloomberg.net.

Last Updated: December 19, 2007 17:03 EST