NEW YORK (Reuters) - The yen shed more than 1 percent of its value against the dollar for a second straight session on Thursday, reaching its lowest level in nearly seven months on expectations that the Bank of Japan will become more forceful in its policy action.
The dollar posted its largest gain against the yen since mid-September after Shinzo Abe, the head of Japan's Liberal Democratic Party and front runner in next month's election, said he wants the Bank of Japan to consider sub-zero interest rates.
Abe, pushing the central bank for bold easing steps, told reporters he wants to work with the BOJ to reverse the yen's strength, which he said hurts the competitiveness of small firms.
The correlation of dollar/yen rate differentials broke down and volatility in the currency pair spiked.
"The catalyst has clearly been politics, including a further step up in political pressure on the BoJ to ease aggressively," said Jens Nordvig, global head of G10 strategy at Nomura Securities in New York.
"We have been positioned for this trade in both spot and options, and the question now is how to balance short-term and medium-term considerations," he said.
The dollar rose to 81.45 yen, its highest level since April 25. It last traded at 81.16, up 1.2 percent on the day. That followed a gain of 1.1 percent the previous day.
Nomura's Nordvig said the "new BoJ" theme, and changing long-term flows, are key reasons his firm forecasts 85 for dollar/yen in early 2013.
"But in the short term, we see more two-way risk, including from Japanese event risk from the BoJ meeting and the trade release next week," he said.
The euro, meanwhile, rallied to a two-week high against the yen, and also rose against the dollar, despite data showing the euro zone slid into its second recession since 2009 in the third quarter of 2012.
"The weakness in the yen is evidence that the market is pointing to the Bank of Japan's potential to become more dovish," said George Saravelos, G10 FX strategist at Deutsche Bank.
"Our forecast is for 82-83 yen for the year-end," he added.
Nevertheless, the Bank of Japan is expected to hold its fire at a meeting of its policy board next week and may also defy market expectations for action in December.
The yen has fallen heavily since Japanese Prime Minister Yoshihiko Noda indicated he would call a snap election in December.
The euro hit a high of 103.98 yen and last traded at 103.74, up 1.5 percent, as investors unwound short euro positions taken earlier this week on concerns about when Greece will receive its next tranche of financial aid.
The International Monetary Fund has done what it can to help Greece reach debt sustainability, an IMF spokesman said, leaving the window open for further action by the indebted country's European lenders.
The IMF has clashed with Greece's other lenders, the European Central Bank and the European Commission, over how to make Greece's debt mountain manageable.
Meanwhile, the European Union's top economic official sought to rule out any write-off of Greece's debt to governments on Thursday after a European Central Bank policymaker said for the first time that a "haircut" on part of it was probable.
The euro last traded up 0.4 percent at $1.2782, recovering from Tuesday's two-month low of $1.2660. Traders cited buying by European corporates earlier in the session that helped lift the euro.
The single currency looked vulnerable with concerns about slowing growth in the euro zone and uncertainty over aid for Greece and Spain seen by analysts as likely to cap gains.
But some analysts said investors were wary of selling the euro heavily in case policymakers surprised markets with decisive action to tackle the debt crisis.
"They don't want to sell into it too aggressively in case there's a policy response from the European Central Bank that would see people get stopped out of shorts," said Geoffrey Yu, currency strategist at UBS.
"But there are plenty of structural problems out there so people do not want to go long either."
While U.S. data influences dollar price action, the greenback will more likely be swayed in the coming weeks by whether politicians in Washington can agree on a debt and deficit reduction deal by the end of the year.
An agreement needs to be made by the end of the year to avoid the so-called U.S. "fiscal cliff," which entails massive tax increases and spending cuts that many say could send the economy back into a recession.
Brinkmanship in Washington over the coming weeks should spur market uncertainty that should benefit the dollar due to its safe-haven status. The greenback should also benefit should the fiscal cliff scenario come to fruition.
The number of Americans filing new claims for jobless benefits surged last week to a 1 1/2-year high. Separate data showed U.S. consumer prices rose in October and a gauge of manufacturing in New York state showed that activity slowed in November for a fourth straight month.
Meanwhile, factory-sector sentiment dropped in the U.S. Mid-Atlantic region.
Additional reporting by Philip Baillie in London; Editing by Peter Galloway