The yen rose on Thursday after the scale of asset purchases by the Bank of Japan disappointed some investors who had positioned for more aggressive easing. Gains in the Japanese currency were expected to be capped however, by the prospect of further easing by the BoJ next year. The Japanese central bank increased its asset buying by 10 trillion yen and said it would debate next month whether there is room to raise its inflation target, a move that could weaken the currency.

Traders took profits on recent bets against the yen, pushing the dollar down 0.4 percent to 84.09 yen and away from a 20-month high of 84.62 yen hit on Wednesday. The dollar has gained more than 6 percent in the past five weeks on anticipation that Japan's new government would push the BoJ to take more aggressive easing steps, and many market players said there was scope for further yen weakness ahead.

"The reaction in the market is one of modest disappointment. Expectations of aggressive BoJ easing have been running ahead of reality," said Lee Hardman, currency economist at Bank of Tokyo-Mitsubishi. Hardman forecast the dollar to trade at 86 yen in 12 months' time and the yen's recent weakening trend was sustainable. The euro was down 0.1 percent on the day against the yen at 111.57 yen, paring losses after earlier falling to a session low of 110.74 yen, and holding below a 16-month high of 112.59 yen hit on Wednesday.

Against the dollar, the euro rose 0.3 percent on the day to trade at $1.3265, not far from the 8-1/2 month high of $1.33085 reached on Wednesday after better-than-expected German business confidence data. The single currency recouped losses run up earlier in the session, with some market players saying concerns about US policymakers not being able to reach a resolution on the "fiscal cliff" were starting to subside.

If a deal is not reached the combination of tax hikes and spending cuts due to kick in early next year could tip the world's largest economy into recession, and may drag on currencies linked to the global growth outlook like the euro and the Australian dollar.

"The market is beginning to sense that despite the recent comments overnight, worries about the US fiscal issue are probably temporary," said Neil Jones, head of hedge fund FX sales at Mizuho Corporate Bank in London. The Republicans announced plans to put an alternative tax plan to a vote in the House of Representatives this week, prompting President Barack Obama to threaten to veto it, thereby unravelling the progress made over the last week. Some market players said investors were mostly positioned for a deal to be reached on time, with some expecting the euro to go as high as $1.3500 by early January.

"At the end of the day, markets are still convinced that a compromise will be reached on the fiscal cliff and thus risk-on should still prevail," said one FX trader, adding euro buying against the dollar and yen would probably continue.

Copyright Reuters, 2012