June 27 (Bloomberg) -- The yen and the Swiss franc may extend their gains after a slump in U.S. stocks encouraged investors to reduce holdings of higher-yielding assets funded by loans in Japan and Switzerland.

The dollar declined yesterday to the weakest level versus the euro in more than two weeks as speculation eased that the Federal Reserve will increase borrowing costs in August. The pound appreciated to a seven-week high against the dollar after Bank of England Governor Mervyn King said policy makers will do what's needed to stem inflation.

``Risk aversion is at elevated levels, and that's benefiting the yen,'' said Samarjit Shankar, director of global strategy for the foreign-exchange group in Boston at Bank of New York Mellon, the world's largest custodial bank, with about $23 trillion in assets under custody. ``There's a lot of investor concern about the Fed's direction and the path of policy makers going forward.''

Japan's currency traded at 106.81 per dollar at 6:01 a.m. in Tokyo, after increasing 0.9 percent yesterday. The yen was at 168.30 per euro, following a 0.4 percent advance yesterday, when it touched a record low of 169.46. The dollar traded at $1.5758 per euro, after dropping 0.6 percent and touching $1.5767, the weakest level since June 9.

The yen and the Swiss franc appreciated yesterday against all of their major counterparts as the Standard & Poor's 500 Index fell 2.9 percent, the most in almost three weeks. Japan's currency increased 2.5 percent to 13.3955 versus the South African rand, and the franc rose 1.8 percent to 1.5666 Brazilian reais. Investors bought the yen and the franc to pay back loans in those currencies used to fund investments in higher-yielding assets, which become less profitable when stocks fall.

Currency Volatility

Implied volatility on one-month dollar-yen options rose yesterday for the first time in three days, increasing to 10.87 percent. Bigger currency swings can wipe out the profits of the carry trade, in which investors borrow in countries with low interest rates and buy assets where returns are higher.

The Bank of Japan will maintain its target lending rate at 0.5 percent, the lowest among industrialized economies, through September of next year, according to the median forecast of 11 economists surveyed by Bloomberg News. The benchmark rates are 2.75 percent in Switzerland, 12 percent in South Africa and 12.25 percent in Brazil.

The pound strengthened after King said in testimony before a parliamentary committee that U.K. inflation will probably exceed 4 percent in the coming months. Sterling increased as much as 0.7 percent to $1.9895, the highest level since May 2, after the BOE governor said ``although inflation is rising now, we will ensure that it falls back to the 2 percent target.''

Fed Rate Outlook

The dollar dropped against the euro as futures on the Chicago Board of Trade showed the chance of the Fed increasing the target rate at its next meeting on Aug. 5 fell to 23 percent, from 44 percent a week ago. The balance of bets was on no rate change.

Crude oil jumped above $140 a barrel to a record yesterday as Libya threatened to cut production and the Organization of Petroleum Exporting Countries' president said prices may reach $170 by the summer. Investors buy commodities as a hedge against the dollar when inflation erodes the value of the U.S. currency.

The Fed left the target lending rate at 2 percent on June 25, saying in a statement at the end of its two-day meeting that ``uncertainty'' about the inflation outlook remains high.

``People are starting to wonder whether the Fed has the guts to raise rates in the first place,'' said Matthew Kassel, director of proprietary trading at ING Financial Markets LLC in New York. ``The dollar could test $1.60 in the next month.''

U.S. Inflation

The Fed's preferred gauge of annual inflation, which excludes food and fuel costs, increased to 2.2 percent in May, from 2.1 percent for the prior month, according to the median forecast of 27 economists surveyed by Bloomberg News. Policy makers including Fed Chairman Ben S. Bernanke have said they prefer core inflation to be below 2 percent. The Commerce Department will deliver its report at 8:30 a.m. Washington time.

The dollar has gained 0.2 percent against the euro this quarter as traders bet the economic slowdown sparked by the collapse of the subprime-mortgage market will spread to Europe as the U.S. recovers.

European Central Bank President Jean-Claude Trichet reiterated on June 25 in a speech before the European Parliament in Brussels that policy makers may increase the 4 percent main refinancing rate by a quarter-percentage point next month to contain inflation.

``The euro is generally benefiting from expectations the ECB will raise rates next week,'' said Marcus Hettinger, a currency strategist in Zurich at Credit Suisse Group, Switzerland's second-biggest bank. ``The ECB is focused on inflation, and that's supporting the euro. It's not the real economic data that's driving the euro.''

To contact the reporters on this story: Candice Zachariahs in New York at czachariahs1@bloomberg.net; Bo Nielsen in New York at bnielsen4@bloomberg.net.

Last Updated: June 26, 2008 17:08 EDT