Canada’s dollar is emerging as the Group of Seven currency with the most at stake as traders debate whether the U.S. Federal Reserve will announce a reduction in its unprecedented monetary stimulus as soon as today.

The loonie and U.S. 10-year Treasury notes yields are the most inversely correlated since August 2004, increasing faster in 2013 than any other G-7 peer apart from the U.S. dollar. That means any rise in U.S. yields should the Fed taper its $85 billion in monthly bond purchases may weaken Canada’s currency, which is already down 6.5 percent this year.

The Canadian dollar is particularly sensitive to Fed policy because the countries are each other’s largest trading partners. The correlation increased as the U.S. considered reducing stimulus and the Bank of Canada stepped back from a pledge to move interest rates higher.

“We’re in the process of seeing a divergence in monetary policy,” Paresh Upadhyaya, the Boston-based director of currency strategy at Pioneer Investment Management Inc., said in a Dec. 16 phone interview. “Canada can be expected to keep a very loose, accommodative monetary policy, in contrast to the Fed, which is set to start its tightening cycle.”

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The dollar slipped against the euro and yen on Tuesday, trading in narrow ranges as investors awaited an announcement from the Federal Reserve on the central bank’s stimulus program.

As the Fed begins its two-day policy meeting on Tuesday, market participants generally expect no major policy changes, though the U.S. central bank could begin to lay the groundwork for a reduction in its economic stimulus that many say could occur in the first quarter of the new year.

“I would be surprised if they actually move to taper asset purchases – and think only a small minority are looking for a taper (on Wednesday), but I see a strong likelihood that this will be a set-up meeting for a move in January,” said John Hardy, head of FX strategy at Saxo Bank in London.

(Reuters) – The dollar dropped from five-year highs against the yen Friday as investors reduced bets on the greenback amid caution ahead of a U.S. Federal Reserve policy meeting next week that may herald a wind-down of its massive stimulus measures.

While market participants in general expect the Fed to pare back its stimulus no later than March, a growing number expect a small reduction in the Fed’s asset purchases from next week. The central bank holds a two-day policy meeting December 17-18.

“The dollar has retraced all its gains against the yen and this is mostly positioning ahead of the Fed meeting and profit-taking on the strong dollar trend we saw this week,” said Greg Moore, currency strategist, at TD Securities in Toronto.

“There’s a lot of uncertainty going into the meeting and some are talking about a small taper next week, although that is not our view. We still think the Fed will wait until January to make any announcement.”

In early New York trading, the dollar fell 0.2 percent to 103.17 yen, after hitting 103.92 in Asian trading, its highest level since October 2008. Traders said there are bids in the 103-yen area and if that goes, there could be more selling of some short-term longs ahead of the weekend.

On the week, the dollar posted minor gains of just 0.2 percent, on track for its best weekly performance since early November.

Marshall Gittler, head of global FX strategy at IronFX Global, who thinks the Fed will begin tapering next week, said he expects dollar/yen to reach 130 yen by the end of next year as Japan’s economic struggles come to the fore.

Other than against the yen, the dollar was generally steady versus other currencies. It was slightly higher against the euro at $1.3732 and was up 0.5 percent versus sterling, which last traded at $1.6274.

The euro also hit a five-year peak against the yen at 142.81, but was last down 0.4 percent at 141.64 yen.

So far this year the dollar has gained 19 percent against the yen while the euro has risen 24 percent, on expectations the Bank of Japan will provide even more stimulus next year.

The euro in general has been resilient despite recent poor economic data, as two-year swap rates rose to their highest levels in a month. The European Central Bank said on Friday that banks will return 22.65 billion euros of crisis loans to it next week, above analysts’ forecasts, tightening liquidity in the bloc.

Citi strategist Valentin Marinov said this can help push the euro higher for now, but it isn’t positive for the euro longer-term as tightening liquidity hits lending and growth.

Liquidity usually tightens towards the end of the year, when banks hold off from lending to each other.

YEN RECOVERS

The yen earlier slumped to a three-decade low against the Swiss franc, with some attributing the broad-based decline to a resumption of its role as a conduit for carry trades given the Japanese central bank’s continued commitment to an ultra-easy monetary policy.

The franc has been buoyed by Swiss banks repatriating money before the year-end. The Swiss franc rose to 116.68 yen, its highest level since early 1983 in Asian trading. But in the New York session, the Swiss franc has retraced its gains to trade 0.3 percent lower to 115.90 yen.

The Australian dollar fell to its lowest in more than three months after central bank governor Glenn Stevens said he would prefer to see the local dollar lower as a boost to trade-exposed sectors of the economy. It was recently flat at US$0.8931.