Jan. 17 (Bloomberg) -- The yen rose after the Federal Reserve and the European Central Bank said economic growth is slowing, prompting speculation they will lower interest rates.

The currency extended this year's gain to 4 percent versus the dollar before Fed Chairman Ben S. Bernanke's testimony in Congress on the economy and approached a four-month high against the euro after ECB council member Yves Mersch cited ``downside risks'' to expansion. The extra yield investors earn on two-year Treasuries over similar-maturity Japanese government debt narrowed to the least since April 2004 this week.

``From an interest-rate gap perspective, the yen is likely to strengthen,'' said Hideaki Inoue, chief manager of derivatives and fixed-income investment in Tokyo at Mitsubishi UFJ Trust and Banking Corp., a unit of Japan's largest publicly traded lender by assets. ``The Fed and the ECB may lower borrowing costs.''

The yen advanced to 157.18 per euro at 7:45 a.m. in London, from 157.72 late in New York yesterday, when it reached 156.29, the strongest since Sept. 10. Japan's currency was at 107.35 per dollar compared with 107.64. The yen may advance to 156.30 versus the euro today, Inoue forecast.

The dollar traded at $1.4648 per euro from $1.4652. Bernanke will reiterate today the central bank will cut interest rates to ease credit-market losses and avoid recession. The dollar fell to 6.9316 South African rand from 6.9517 and was little changed at $1.9646 to the British pound.

U.S. Rates

Bernanke said last week that more interest-rate cuts ``may well be necessary'' to buttress growth. He testifies on the economic outlook at 10 a.m. in Washington before the House Budget Committee. The yield premium investors earn on two-year Treasuries over similar-maturity Japanese bonds fell to 1.86 percentage points on Jan. 15.

Fed funds futures contracts on the Chicago Board of Trade show a 100 percent likelihood the Fed will lower its target for the overnight lending rate between banks by at least a half- percentage point to 3.75 percent on Jan. 30. The chance of a cut to 3.5 percent is 40 percent, compared with zero a week ago.

Futures indicated traders started to bet the ECB will lower borrowing costs this year for the first time since 2003. The implied yield on three-month Euribor June futures contracts was at 4.085 percent today, down from 4.375 percent a week earlier.

Margin Trading

The British pound weakened to 210.79 yen from 211.35 as global rate cuts give Japanese investors less incentive to buy overseas assets. The Bank of Japan will keep its overnight lending rate unchanged at 0.5 percent at its two-day meeting starting Jan. 21, according to all 38 economists surveyed by Bloomberg News.

So-called net short positions on the yen versus seven major currencies, or wagers it will fall, dropped to 227,479 contracts among retail investors on Jan. 16 from 249,918 on Jan. 15, data from the Tokyo Financial Exchange showed today. Investors reduced net long positions on the U.S. dollar to 76,634 from 80,925 and on the Australian dollar to 47,162 from 48,516.

The Bank of Japan in December last year estimated the Tokyo Financial Exchange's share of the nation's margin trading was 5.8 percent. Japanese investors have 1,536 trillion yen ($14.3 trillion) in financial assets, according to figures released by the Bank of Japan on Dec. 17.

Subprime Fallout

Delinquencies on mortgages U.S. homeowners with poor credit have depleted capital at Merrill Lynch & Co. and Citigroup Inc., forcing them to seek more than $13 billion from foreign investors. Merrill Lynch, the world's biggest brokerage, probably will post a loss of $3.23 billion today, analysts estimate.

``There will be a lot more losses on subprime loans at major banks,'' said Masanobu Ishikawa, general manager of foreign exchange at Tokyo Forex & Ueda Harlow Ltd., Japan's largest currency broker. ``The risks are leaning more toward further dollar weakness.''

The dollar may decline to 106.80 yen today, he said.

Europe's ``downside risks to economic activity'' include a stronger euro, near-record oil prices, the slowing U.S. economy and higher credit costs, the ECB's Mersch said in a Jan. 15 interview in Luxembourg.

``The eurozone economy is unlikely to be immune to the U.S. economic slowdown,'' said Masashi Kurabe, head of currency sales & trading at Bank of Tokyo-Mitsubishi UFJ Ltd. in Hong Kong. ``The euro hasn't priced in a rate cut, so a change in that direction means the currency may weaken.''

The euro may decline to $1.4570 today, Kurabe forecast.

ECB President Jean-Claude Trichet and council member Klaus Liebscher will speak in Frankfurt and Brussels, respectively. The yield spread between 10-year German and Japanese government bonds narrowed to 2.58 percentage points today, the least since Dec. 6.

To contact the reporter on this story: Stanley White in Tokyo at white28@bloomberg.net; Ron Harui in Singapore at rharui@bloomberg.net

Last Updated: January 17, 2008 03:14 EST