Market LookBeck II

(Reuters) - The dollar rallied to a 4-1/2-year high against the yen and a near three-year peak against a currency basket on Wednesday after Federal Reserve Chairman Ben Bernanke stoked speculation the U.S. central bank could begin slowing its asset buying in coming months.

Bernanke, in testimony to Congress, said the Fed's massive bond-buying program would remain in place for now. But he added if economic improvement continued, the Fed could "in the next few meetings take a step down" in its purchases and warned that holding interest rates too low for too long has its risks.

The dollar initially sold off after Bernanke said monetary stimulus is helping the U.S. economy recover and it was too soon to remove existing measures. It then rebounded and surged to the day's highs as traders focused on the possibility of the Fed reducing its bond buying later this year.

"The takeaway from his speech is clear which is that the Fed is serious about winding down QE and all of the speculation surrounding this possibility is validated," said Kathy Lien, Managing Director of FX Strategy for BK Asset Management in New York.

"The U.S. dollar has been on a tear since the beginning of the month and should extend its gains now that Bernanke green-lighted the rally."

The dollar has risen more than 5 percent so far this year against a basket of currencies on expectations the beginning of the end of the Fed's bond-buying program might come sooner than many investors think.

But those hopes faded somewhat this week after several Fed officials dampened speculation the Fed may change its policy stance any time soon.

The dollar rose to a session peak of 103.73 yen, according to Reuters data, the highest since October, 2008. It was last up 0.7 percent on the day at 103.21 yen.

Against a basket of currencies, the dollar index rose to 84.422, the highest since July 2010. It was last at 84.319, up 0.54 percent on the day.

The euro slipped 0.4 percent to $1.2862, retreating from a one-week high of $1.2998 set before Bernanke's speech.

In a sign of divisions on the policy-setting Federal Open Market Committee, minutes of the latest meeting released Wednesday highlighted an active debate over how soon the Fed should start to scale back its bond-buying stimulus.

SWISSIE A FOCUS

The euro hit a two-year high against the Swiss franc of 1.2648 francs after Swiss National Bank chief Thomas Jordan did not rule out negative interest rates and said policymakers could adjust the euro/franc currency cap if necessary. It was last at 1.2601, up 0.7 percent.

The U.S. currency climbed to a nine-month peak against the Swiss franc of 0.9838 franc, and was last at 0.9795 franc, up 1 percent on the day.

UBS said its forecasts for the euro/Swiss franc and the dollar/Swiss franc are 1.27 and 0.99 in three months' time but there are upside risks to its targets.

The euro hit a 3-1/2-year high of 133.77 yen, before pulling back to 132.70 yen, up 0.3 percent on the day. So far this year, it has gained 16 percent.

Traders said the yen was likely to come under more pressure once outflows gather pace from Japanese investors seeking higher yields overseas.

The Bank of Japan kept policy steady on Wednesday, as expected, and upgraded its assessment of the economy.

Governor Haruhiko Kuroda said he did not expect long-term rates to spike given the scale of the BOJ easing and reiterated that there was no change in the goal of achieving 2 percent inflation.

"The (Abe) administration is looking for further yen weakness, but we think the pace will slow," said Chris Walker, currency strategist at Barclays in London.

Sterling fell to a two-month low against the dollar after an unexpectedly sharp drop in retail sales sparked concerns the Bank of England could opt for more monetary easing in the coming months.