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NEW YORK The dollar slid against high-yielding currencies such as the Australian dollar, while the yen sold off on Wednesday after U.S. lawmakers forged a last-minute deal to avert huge tax increases and spending cuts, fuelling demand for riskier investments.
Investors tend to sell the dollar and yen, both highly liquid currencies, when risk appetite is strong.
But the dollar's and yen's losses could be temporary because of potentially contentious negotiations ahead about spending restraints and the debt ceiling.
U.S. Treasuries fell on the fiscal agreement as investors felt comfortable moving away from the safety of government bonds, while equities posted sharp gains.
The dollar, however, rebounded against the euro, as some traders booked profits after driving the common currency to a two-week high just below $1.33.
Although the passage of the bill to avoid the "fiscal cliff" removed some near-term uncertainty, it did not end the political showdown on the budget. Battles over the sequester, as the automatic spending cuts are known, and the U.S. debt ceiling will come to a head in February.
"While the U.S. is not now plunging off a fiscal cliff, it's still going down a steep fiscal ski hill that will take a meaningful bite out of economic growth," said Avery Shenfeld, chief economist at CIBC World Markets in Toronto.
"The sense of closure that investors are feeling today could soon dissipate as the focus shifts to the bargaining ahead."
Higher-yielding and growth-linked currencies rallied. The Australian dollar rose 0.9 percent to US$1.0497 after hitting a two-week high. The New Zealand dollar gained 0.7 percent to US$0.8338, while the Canadian dollar rallied versus the greenback, which fell 0.7 percent to C$0.9858.
The euro fell 0.2 percent to $1.3185. It had earlier hit a high of $1.3299, according to Reuters data, the highest in two weeks, and not far from an 8-1/2-month high on December 19.
"It looks as though someone forgot to tell the euro that it's supposed to go higher after the fiscal cliff agreement," said Matthew Lifson, senior analyst and trader at Cambridge Mercantile Group, in Princeton, New Jersey.
The euro has gained nearly 10 percent since late July when European Central Bank President Mario Draghi said the ECB would do "whatever it takes" to save the euro.
Strategists, however, said the euro could see renewed pressure if concerns about the weak euro-zone economy re-emerge.
Euro-zone factories sank deeper into recession in December, data showed on Wednesday. Markit's Eurozone Manufacturing Purchasing Managers' Index (PMI) fell to 46.1 from November's 46.2. It has been below the 50 mark that divides growth from contraction since August 2011.
In contrast, data on Wednesday showed U.S. manufacturing ended 2012 on an upswing despite fears about the fiscal cliff, with factories returning to growth in December after contracting the previous month, according to the Institute for Supply Management.
"All the noise (on the fiscal cliff) from the end of the year in the U.S. is over," said Cambridge's Lifson. "It may be time to concentrate on the economies, and at present, it looks like European economies are in worse shape than the U.S. economy. Advantage, U.S. dollar? It just may be."
On Friday, the ISM services data and the closely watched U.S. non-farm payrolls data for December will be released.
The euro rose 1.3 percent to 115.99 yen on Reuters data, the strongest since July 2011, and was last up 0.5 percent at 115.07 yen. Option barriers were cited at 116 yen.
The dollar rose 0.7 percent to 87.26 yen, having touched 87.33 yen earlier, the highest since late July 2010.
The yen has also come under pressure in recent weeks on expectations that a new Japanese government will push the Bank of Japan into more forceful monetary easing.
Speculators' bets against the yen hit more than five-year peaks in December, but have eased in the past two weeks. Some strategists warned of a potential rebound in the yen after the next BOJ meeting on January 21-22.
In the options market, one-month dollar/yen implied volatility touched an 8-1/2 month high of 9.2 on Wednesday, according to Thomson Reuters data, as demand to hedge against further yen weakness gathered pace. It was last at 8.65 vols, some way off the mid-December low of 7.1.
(Reporting by Gertrude Chavez-Dreyfuss; Additional reporting by Wanfeng Zhou; Editing by Jan Paschal)