The Thai baht staged its largest one-day fall in three years on Tuesday after Thai armed forces said they had taken control of Bangkok, which led to a broad-based decline in a number of Asian currencies.

The Japanese yen meanwhile retained most of the day's gains against the euro after a European official overnight said markets had not yet digested policy makers' comments at the weekend G7 meeting that yen should rise against the euro.

But the Japanese currency eased around half a yen from session highs against the dollar after the Thai news, tracking a sharp decline in the baht. Some strategists viewed the move as a simple knee-jerk reaction, as the more-liquid Japanese currency sometimes trades as a proxy for less flexible Asian currencies.

Why would domestic politics in Thailand cause more than a knee-jerk reaction to sell yen, said Rebecca Patterson, senior global currency strategist at J.P. Morgan in New York.

Developments in Thailand overshadowed U.S. data earlier that showed a surprisingly large fall in housing and the rate of wholesale inflation that weighed on the dollar.

The dollar was last at 117.62 yen, off 0.3 percent on the day but up from 117.05 before the news of the Thai emergency appeared on the wires.

Prime Minister Thaksin Shinawatra, who was in New York at a United Nations summit, declared a severe state of emergency in a voice broadcast on Thai television.

There is a risk we might see pressure among some of Thailand's neighbors. Not that there is a serious risk of political contagion or anything. But in terms of sentiment you could see Indonesia, for instance, also under a fair amount of pressure, said Mike Moran, currency strategist at Standard Chartered in New York.

A trader with a Japanese bank said the move in dollar/yen was the result of short-covering after the news in Thailand.

Against the Thai baht the dollar rose to 37.78 baht, up from 37.305 and up over 1.3 percent on the day in the largest daily rise since October 2003.

Against the Korean won, the dollar was up by nearly 0.5 percent at 951.60 won, and versus the Philippine peso, the dollar was up 0.1 percent at 50.030 pesos.

WEAK EUROZONE DATA

Elsewhere, weak economic data undermined the euro fairly broadly as well, after Germany's key ZEW survey on investor sentiment hit an eight-year low in September.

We're kind of being batted by downside surprises in Europe and downside surprises in the U.S., said Lara Rhame, senior currency strategist at Credit Suisse in New York.

More than anything else, central bank expectations remain the key driver and I think the dollar could see some recovery tomorrow. I just don't think we're going to get anything new or different from the Fed, she said.

The market has seen hawkish comments from European Central Bank officials recently, while there are heightened expectations the Federal Reserve will signal at its meeting on Wednesday it will keep rates at 5.25 percent for the rest of the year.

Despite the intense focus in the market on inflation, it was the August housing starts that initially curbed the dollar's rise against the euro earlier in the day.

The weakness in the housing market came as no surprise to the market but its extent caught a few traders unawares.

U.S. housing starts dropped 6.0 percent last month to an annual rate of 1.665 million units from 1.772 million in July, the slowest pace since April 2003.

The euro was last at $1.2671, down about 0.2 percent Against the yen, the euro pared some of its losses but was still down 0.4 percent at 149.09 yen.

Another U.S. government report showed a 0.4 percent fall in inflation excluding food and energy prices at the factory and farm gate in August, below expectations for a 0.2 percent pickup. [ID:nN18300703].

It's certainly all consistent with the idea that the Fed is staying on hold, said Alan Ruskin, chief international strategist at RBS Greenwich Capital in Greenwich, CT. (Additional reporting by David McMahon, Kevin Plumberg and Steven C. Johnson)

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