Oct. 11 (Bloomberg) -- The yen dropped to a 10-week low against the euro after the Bank of Japan kept its interest rate at 0.5 percent, the lowest in the industrialized world.

The yen weakened against all 16 of the most active currencies as the rate decision spurred demand for higher- yielding assets bought with borrowed Japanese currency, sending Asian equity stock indexes to a record. The implied volatility on one-month euro-yen options fell to a 10-week low today, encouraging so-called carry trades.

``While volatility remains low, carry currencies are going to be favored,'' said Paul Robson, a strategist at Royal Bank of Scotland Plc in London. ``The yen is going to remain under pressure, particularly against high-yielding currencies.''

The Japanese currency declined to 166.98 versus the euro, the lowest since July 24, before trading at 166.95 at 8:05 a.m. in New York, from 165.84 late yesterday. The yen rose to 117.59 per dollar from 117.24.

Japanese machinery orders fell a more-than-expected 7.7 percent in August, after gaining 17 percent the month before, a Cabinet Office report showed today, weakening the central bank's case for a rate increase this year.

The BOJ voted 8-1 to keep rates on hold, with board member Atsushi Mizuno the only dissenter. All 39 economists surveyed by Bloomberg predicted the decision.

The central bank needs more time to gauge the effect of the U.S. subprime-mortgage crisis on the global economy, Governor Toshihiko Fukui said after the decision.

Japanese policy makers have ``seen some improvement in global financial markets, yet some uncertainties remain,'' Fukui, 72, told reporters in Tokyo. ``The biggest uncertainty right now is how much U.S. housing prices will fall.''

`Funding Currency'

``There's no reason for the yen to stop weakening,'' said Tsutomu Soma, a bond and currency dealer at Okasan Securities Co. in Tokyo. ``The yen will remain an attractive funding currency for its low rates.'' It may fall to 170 by year-end, Soma forecast.

Australia's dollar rose to a 10-week high of 106.27 yen from 105.29 yen late in New York yesterday. New Zealand's dollar advanced to an eight-week high of 90.58 yen from 90.14 yen.

In carry trades, investors borrow in low interest-rate countries, such as Japan, to buy assets in nations such as New Zealand, where borrowing costs are 8.25 percent, or Australia, where rates are 6.5 percent. The risk is that currency fluctuations will erase any profit from the difference in rates.

One-month implied volatility for euro-yen options fell to 8.55 percent today, from 8.85 percent yesterday, and down from 9.85 percent a week ago.

Euro Gains

The euro rose for a third day against the dollar after European Central Bank President Jean-Claude Trichet said economic expansion remains ``robust'' in the 13-nation euro region and external trade is ``dynamic.''

The common currency strengthened to $1.4199, from $1.4145 yesterday.

European economic growth continues to ``hover around potential,'' Trichet said at a press conference in Moscow today.

The dollar's losses against the euro may be tempered by speculation Federal Reserve Governor Randall Kroszner will today express confidence U.S. financial markets are improving, reducing the need for the central bank to lower interest rates further to bolster growth.

Traders reduced bets on a Fed rate cut this month after minutes of the Sept. 18 meeting showed policy makers aren't convinced the economic expansion is coming to an end.

``Kroszner may signal the worst is over,'' said Lee Wai Tuck, a currency strategist at Forecast Singapore Ltd. ``It would be supportive of the dollar,'' which may rise to $1.4080 per euro and 117.50 yen today, he said.

Odds of Fed Cut

Kroszner speaks at 10:45 a.m. in Durham, North Carolina. Three Fed bank presidents said this week credit-market conditions have improved.

Futures contracts on the Chicago Board of Trade indicate a 36 percent chance the Fed will cut its benchmark rate a quarter- percentage point to 4.5 percent at its meeting Oct. 31, compared with 72 percent odds a week ago.

To contact the reporters on this story: Gavin Finch in London at gfinch@bloomberg.net; Stanley White in Tokyo at swhite28@bloomberg.net

Last Updated: October 11, 2007 08:12 EDT