The dollar weakened broadly on Wednesday, striking a record low versus the euro and a 26-year trough against sterling as growing fears surrounding the U.S. subprime mortgage and credit sectors gripped financial markets.

These concerns, heightened on Tuesday after two ratings agencies issued warnings on more than $17 billion of debt linked to risky mortgages, made investors less willing to take on risk.

This helped trigger a sharp selloff in equity markets, a slide in bond yields, a rise in implied FX volatility and some unwinding of carry trades -- where low yielders like the yen are sold for higher return units such as the New Zealand dollar.

The Federal Reserve's broad dollar index on Tuesday showed the greenback's nominal, weighted value at its lowest level in a decade. Against a selection of major currencies, the dollar hit its lowest level ever in the free-floating currency period since the Fed's records began in 1973.

We continue to see two themes play out: the dollar taking the brunt of concerns about credit markets, and whether this should lead to more substantial risk aversion and unwind of carry positions, said Laura Ambroseno, currency strategist at Morgan Stanley in London.

Near term, these credit concerns should drive currencies, and that means the dollar remains under a bit of pressure.

At 1200 GMT the euro was up 0.2 percent on the day at $1.3770, having earlier set a record high of $1.3784, according to Reuters data.

Sterling was up a third of a percent at $2.0335, having hit a 26-year peak of $2.0351, while dollar recovered from a one-month low of 121.02 yen to trade at 121.55 yen, still down on the day, however.

EURO RISE NOT DRAMATIC

The dollar's sell-off on Tuesday was exacerbated by reports from credit rating agencies Standard & Poor's and Moody's Investors Service on Tuesday that warned on over $17 billion of debt related to risky mortgages, much of it subprime. Subprime loans are extended to borrowers with poor credit.

The effect across financial markets was stark.

Ten-year Treasury yields slumped back below 5 percent, equities tumbled, measures of risk spiked up and implied volatilities on short-term currency options jumped.

The dollar index fell to a 2-1/2 year low of 80.620.

Against the background of narrowing rate differentials and potentially weaker foreign inflow into U.S. credit products, it was no surprise to see the dollar weakening further, wrote Goldman Sachs strategists in a note to clients on Wednesday.

U.S. subprime worries prompted markets to price in a greater risk of a Federal Reserve interest rate cut this year or next.

In contrast, other central banks around the globe are expected to continue tightening monetary policy, with yield differentials thus set to move to the detriment of the dollar.

The Bank of Japan is widely expected to hold interest rates steady on Thursday, although some of the more hawkish members of the board may vote for a hike to 0.75 percent.

Clearly with the weakness in equities and concerns about the U.S. housing market it is probably not surprising to see some short covering and unwinding of carry trades. But I would be very cautious to call this a general turn against carry, said Michael Klawitter, currency strategist at Dresdner Kleinwort in Frankfurt, adding that the euro is on track to target $1.40.

But European Central Bank Governing Council member Vitor Constancio said on Wednesday the euro's rise has not been dramatic, noting that its effective exchange rate against the dollar is only up 4.5 percent since the currency's 1999 launch.

Morgan Stanley