The yen rallied from the previous day's two-month lows versus the euro and dollar on Tuesday, while the New Zealand dollar fell sharply as a sell-off in European equities underlined a diminished appetite for risk.

Reduced risk appetite prompts investors to scale back carry trade investments where cheap borrowing in the low yielders like the yen funds purchases of higher return currencies such as the New Zealand dollar.

Risk aversion also benefited the U.S. dollar versus the euro, with the greenback increasingly trading like a low yielder due to expectations of more rate cuts from the Federal Reserve.

The FTSEurofirst 300 index of European shares fell around 0.6 percent, tracking weakness in Asian and U.S. equities overnight sparked by a gloomy outlook from Citigroup.

Investors are monitoring reports from the financial sector carefully for clues on how deeply it has been affected by troubles in the U.S. subprime mortgage sector and the subsequent credit crunch. JP Morgan and Bank of America are among those reporting their third quarter results this week.

There is a bit of focus on risk aversion, with the global equity markets in a sell-off sentiment and we are seeing the yen and also Swiss franc firmer, said Niels Christensen, FX strategist at Nordea in Copenhagen.

By 3:30 a.m. EDT, the dollar was down half a percent at 116.77 yen, retreating from Monday's two-month high of 117.94.

The euro slid 1 percent to 165.02 yen after hitting 2-1/2 month peaks of 167.72 the previous day.

The New Zealand dollar, a carry trade favorite, fell 3 percent to 86.79 yen.

The euro fell 0.3 percent to $1.4166.

Risk aversion picked up from recent three-month lows with the UBS FX risk index rising to 0.45 from 0.36.

DATA WATCH

In the euro zone, investors were looking ahead to the ZEW October index of German investor sentiment at 5:00 a.m. EDT for signs of how well the bloc's biggest economy is coping with the strong euro and the recent turbulence in financial markets.

The final estimate for euro zone September inflation is also due at 5:00 a.m. EDT.

Despite acknowledging increasing uncertainty over, and downside risks to, the growth outlook, the European Central Bank has retained a hawkish tone. In contrast, the Federal Reserve slashed rates by 50 basis points to 4.75 percent last month and is widely expected to loosen policy again by year-end.

Traders showed limited reaction to a speech by Fed Chairman Ben Bernanke, who said late on Monday that U.S. financial markets are healthier after a turbulent summer, and that the Fed would support market stability as well as non-inflationary growth.

Tuesday features the release of TICs U.S. investment flows data for August at 9:00 a.m. EDT and September industrial output at 9:15 a.m. EDT.

With the dollar ignoring positive U.S. data and sentiment still negative, any reaction to today's US TIC capital flow data and industrial production may be skewed to the downside, Commerzbank Corporates and Markets said in a research note.

Elsewhere, the Canadian dollar held near Monday's three-decade highs versus the U.S. currency ahead of a Bank of Canada decision later in the session, with rates widely expected to be left on hold at 4.5 percent.

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