Dollar drops vs yen, Asia stocks struggle as Fed looms

By Kevin Buckland

TOKYO (Reuters) -The dollar ceded some of its overnight gains on Wednesday while Asian stocks struggled as traders weighed the odds of a super-sized Federal Reserve interest rate cut later in the day.

The U.S. currency dropped back sharply against the yen, handing back about half of its rally from Tuesday, when unexpectedly robust U.S. retail sales data was taken as weakening the case for aggressive Fed easing.

However, short-term U.S. bond yields ticked slightly higher.

The chances of the Fed kicking off its easing cycle with a super-sized cut of 50 basis points (bps) oscillated in Asia, retreating to 63% early in the day from 67% around the same time on Tuesday, before stabilising around 65%, according to LSEG data.

Japan's Nikkei stock average climbed as much as 1.3% early on in reaction to overnight weakness in the yen, but pared those gains to just 0.23% as of 0526 GMT as the currency rebounded.

China's blue chips slipped 0.18% after coming back online following a holiday-extended weekend, and Taiwan also returned from a day off to tumble 1%. Australia's benchmark sagged 0.1%.

MSCI's broadest index of Asia-Pacific shares outside Japan slid 0.27%.

Hong Kong and South Korea were among major markets closed for holidays.

Wall Street finished nearly unchanged on Tuesday, failing to sustain early momentum that pushed the S&P 500 and Dow to record intraday highs. S&P 500 futures pointed 0.06% higher on Wednesday.

Pan-European STOXX 50 futures were weaker though, down 0.19%.

"The (U.S.) price action conveys the significant inflection point markets confront," said Kyle Rodda, senior financial market analyst at Capital.com.

"If the Fed nails it at this meeting, the bull market could charge on. If it doesn't, then it could signal a high water mark in this cycle."

The dollar dropped 0.67% to 141.365 yen, although that followed a 1.26% surge overnight.

The euro added 0.05% to $1.1119. Sterling was steady at $1.3158.

At the same time, two-year U.S. Treasury yields rose slightly to stand at 3.5962%, extending Tuesday's advance.

Commonwealth Bank of Australia analyst Kristina Clifton expects a quarter-point rate reduction from the Fed, "because history shows that the FOMC needs a good reason to start their cutting cycle with more than a 25 bps cut."

But in the event of a more aggressive easing, the dollar's reaction could vary dramatically, she said.

"A 50 bps cut that scares markets about U.S. economic prospects could increase the USD because it is a safe haven currency," Clifton said. "However, a 50 bps cut that eases concerns about U.S. economic prospects could undermine the USD."

Meanwhile, gold struggled to find its feet on Wednesday, slipping 0.1% to $2,567 per ounce after retreating from an all-time high in the previous session.

Crude oil also pulled back after gaining about $1 a barrel on Wednesday amid escalating tensions around the Middle East.

Militant group Hezbollah vowed retaliation against Israel after pagers detonated across Lebanon on Tuesday, killing at least eight people and wounding nearly 3,000 others.

Meanwhile, the UN's Libya mission said factions did not reach a final agreement in talks aimed at resolving the central bank crisis, which has slashed oil output and exports.

U.S. crude futures declined 49 cents to $70.70 in the latest session, and Brent crude futures lost 47 cents to $73.23.

(Reporting by Kevin Buckland; Editing by Shri Navaratnam and Jacqueline Wong)