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The safe-haven Swiss franc and Japanese yen pared gains on Friday after Tehran signalled that it has no plans to retaliate against Israel, which launched what has been described as a limited-scale attack on Iran overnight.
Both currencies jumped against their peers after news of Israel's action, but their gains have eased a bit. Both though still traded higher on the day.
In late morning trading, the U.S. dollar fell 0.4% against the Swiss franc to 0.9088 franc CHF=EBS . It dropped as low as 0.9011 franc overnight, a roughly two-week low, following news of Israel's move.
Against the yen, the dollar was last slightly down at 154.57 yen JPY=EBS . The greenback slid to as low as 153.59 yen after Israel's news.
Iranian media and officials described a small number of explosions, which they said resulted from air defenses hitting three drones over the city of Isfahan in central Iran. A senior Iranian official told Reuters there were no plans to respond against Israel for the incident.
"Every time we have a geopolitical shock, we get an unwinding of the carry trade," said Boris Kovacevic, global market strategist at Convera in Vienna, Austria, referring to trades that use low-yielding currencies such as the Swiss franc and yen to buy higher-yielding units such as the U.S. dollar and the Canadian currency.
"But once people recognize that the short-term implications doesn't extend to the medium term -- for instance, the retaliation of Israel not being severe and harsh as expected -- we see a pulling back from these extreme levels."
People familiar with the matter told Reuters that Israel attacked Iran days after Iran launched an unprecedented assault on Israel in response to a suspected Israeli strike on its consulate in Syria.
Markets initially reacted sharply to the news of the latest Israel initiative, which sparked a sell-off in risk assets, caused oil and gold prices to jump, and ignited a rally in U.S. Treasuries and safe-haven currencies.
The U.S. dollar index =USD , which tracks the currency against six major peers, also rose but then gave up its gains to stand down 0.2% on the day at 105.92.
"My perception is the media in Iran have essentially downplayed the whole thing," said Francesco Pesole, currency strategist at ING. "(That) could be an indication they don't want to escalate further."
He added: "It's speculating here because the news that we're getting is not really clear ... obviously, the situation will remain volatile."
Currencies bounced around throughout the European morning session, with the euro EUR=EBS initially falling but it was last up 0.3% at $1.0671. The British pound GBP=D3 was flat at $1.2439.
The broad theme of the last few weeks has been a surging U.S. dollar on the back of a strong American economy. The euro has been down 1.3% so far this month, while sterling has fallen 1.5%.
Hot data, especially figures last week showing inflation rose to 3.5% in March, has caused traders to rapidly downsize their bets on Federal Reserve interest rate cuts this year to price in two reductions, most likely starting in September. That has caused U.S. bond yields to spike, boosting the dollar index to its highest since November earlier this week.
"Investors are still focused on the Fed mainly, instead of geopolitics," Convera's Kovacevic said. "The broader, bigger picture is the higher for longer theme in the U.S. rates."
Asian currencies have come under particular pressure, and finance chiefs in the United States, Japan and South Korea this week issued a rare trilateral warning over the two Asian nations' sliding exchange rates, raising the prospect of a potential joint intervention.
Bank of Japan Governor Kazuo Ueda said on Thursday the central bank may raise interest rates again if the yen's declines significantly push up inflation, highlighting the impact currency moves may have on the timing of the next policy shift.
Ueda's comments come ahead of the BOJ's monetary policy meeting next week. Data on Friday showed Japanese core inflation slowed to 2.6% year-on-year in March, from 2.8%, although remained above the central bank's 2% target.
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