Oct. 22 (Bloomberg) -- The yen traded near a three-year high against the euro on speculation central banks will lower borrowing costs to limit the global economic slump, encouraging investors to sell higher-yielding assets funded in Japan.

Canada's dollar dropped to the lowest level against the greenback since August 2005 yesterday as the Bank of Canada cut its main lending rate. The U.S. dollar rose to a 20-month high against the euro on bets the European Central Bank will reduce interest rates at a faster pace than the Federal Reserve.

``This very volatile, nervous financial situation we have globally is playing into the hands of the dollar and the yen,'' said Steven Barrow, a currency strategist at Standard Bank Plc in London, in an interview on Bloomberg Radio. ``I do think the Federal Reserve will cut rates again, but we should see much more significant cuts in Europe.''

The yen traded at 130.80 per euro at 6 a.m. in Tokyo, after gaining 3.8 percent yesterday and touching 130.67, the strongest level since June 2005. The dollar was at $1.3063 per euro after rising 2.1 percent and reaching $1.3051, the strongest level since February 2007. The yen traded at 100.14 per dollar, following a 1.7 percent gain.

Brazil's real slid 5.4 percent to 2.2386 per dollar yesterday and South Africa's rand dropped 4.3 percent to 10.6470 per dollar as concern the global economy will fall into a recession led investors to sell emerging-market currencies.

``Emerging-market currencies are getting hit,'' said Richard Franulovich, a senior currency strategist at Westpac Banking Corp. in New York.

Argentine Bonds

Argentine bonds plunged and stocks sank yesterday on speculation the government will nationalize pension funds to obtain financing and stave off a second default this decade. The peso was little changed at 3.2190 versus the dollar.

Canada's currency dropped as much as 2.5 percent to C$1.2208 per U.S. dollar yesterday after the Bank of Canada reduced its benchmark interest rate by a quarter-percentage point to 2.25 percent. Policy makers said in a statement that ``some further monetary stimulus will likely be required.''

Japan's yen rose 7.3 percent to 44.82 versus the Brazilian real yesterday and 6.4 percent to 14.52 against Norway's krone on bets investors will unwind carry trades, in which they get funds in a country with low borrowing costs and buy assets where returns are higher. Japan's 0.5 percent target rate compares with 13.75 percent in Brazil and 5.25 percent in Norway.

Investors bet the ECB will lower borrowing costs by another 0.75 percentage point by June after cutting the main refinancing rate by a half-percentage point to 3.75 percent on Oct. 8, part of coordinated reductions by major central banks.

Euribor Futures

The implied yield on the three-month Euribor contract expiring in June fell to 3.23 percent yesterday, the lowest level since January 2006. The yield has been 0.23 percentage point higher than the benchmark rate on average over the past year. The Fed will cut its 1.5 percent target rate by at least a quarter- percentage point at its Oct. 29 policy meeting, futures on the Chicago Board of Trade indicate.

``The economic fallout of the crisis will lead to more aggressive policy actions in major countries,'' said Tom Fitzpatrick, global head of currency strategy at Citigroup Global Markets Inc. in New York. ``The yen and the dollar will be the beneficiaries.''

The euro will depreciate to $1.26 in eight weeks, said Fitzpatrick, adding he's recommending clients buy the dollar and the yen ``pretty much against everything.''

The dollar has gained 22 percent since touching a record low of $1.6038 per euro on July 15 on speculation the U.S. currency will benefit as the European economy slows.

Stop Losses

The U.S. currency's advance against the euro accelerated yesterday after stop losses on investors' long positions on the euro were activated when $1.3260 was broken, said Antje Praefcke, a currency strategist in Frankfurt at Commerzbank. A stop loss is an automatic order to sell an asset should it reach a particular level.

The ICE's Dollar Index, which tracks the greenback versus the currencies of six major U.S. trading partners, touched 84.46 yesterday, the highest since March 2007.

``The element of risk aversion helps the dollar and the yen, which has been the trend for a while,'' said Paresh Upadhyaya, who helps manage $50 billion in currency assets as a senior vice president at Putnam Investments LLC in Boston. ``The convergence of interest rates will overtake the risk aversion element to become the most important support for the dollar going forward.''

To contact the reporter on this story: Ye Xie in New York at yxie6@bloomberg.net

Last Updated: October 21, 2008 17:02 EDT