The yen dropped against the euro and dollar on Wednesday as investors took recovering U.S. stock markets as a cue to slash short-term bets that the Japanese currency would strengthen.

Foreign exchange dealers have been using global equity markets as a gauge of risk appetite, especially because the tightening credit market has lifted volatility and scaled back the carry trade, in which investors borrow cheaply in currencies such as yen to buy higher-yielding, riskier assets.

This is just a correction from yesterday, said David Powell, currency analyst with IDEAGlobal in New York. The market in general is less panicky in terms of the subprime problem.

On Tuesday, the yen rose sharply in tandem with tumbling global stocks, as traders cut back carry trade bets on greater apprehension of the fallout from the U.S. subprime mortgage meltdown.

However, on Wednesday, the dollar climbed more than 1 percent to 115.49 yen, rebounding from an earlier one-week low of 113.88 earlier in the session, as U.S. stock indices surged after falling more than 2 percent on Tuesday.

At current prices, the dollar was on pace for the biggest daily gain on the yen since at least October 2006, according to Reuters data.

The euro rocketed 1.6 percent to 157.87 yen, and also rose 0.5 percent against the dollar to $1.3672.

The euro's gain on the yen so far in the day was the biggest since January 2005.

Sterling climbed 0.8 percent to $2.0180.

The Australian dollar edged up 0.5 percent to US$0.8181, notably modest gains considering how much the low-yielding yen had fallen.

CAUTION, VOLATILITY AHEAD

Soft data from the U.S. housing and consumer sectors and news of more financial institutions being affected by troubles in the U.S. subprime mortgage sector led to a broad sell-off in risky assets earlier in the week.

But on Wednesday, investors cashed in on the yen's two-day rally, heartened by the solid rise in Wall Street stocks, despite more signs of difficult credit conditions in short-term money markets.

Caution was still the word on most analysts' lips, particularly as dealers wondered whether tough lending conditions would elicit easing in the Federal Reserve's monetary policy.

You have to treat the price action very cautiously right now, and it's a very short term game. People are not that willing to believe that the worst is over but they are also not that willing to believe that there is still plenty more negative news to come, said Paul Mackel, senior currency strategist at HSBC.

U.S. economic growth data on Thursday and inflation figures on Friday could give investors a clearer picture on how the recent market turbulence might have affected the real economy, ahead of the keenly watched payrolls report the following week.

Speculation is rising that the Fed might cut the benchmark fed funds rate from 5.25 percent at its next meeting in September, although the central bank maintained its focus on inflationary risks in its August minutes.

How Fed Chairman Ben Bernanke characterizes the surge in financial market volatility of the last month in a speech on Friday could very well determine the outlook for risk taking.

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