By Anooja Debnath
LONDON (Reuters) - The yen fell against the dollar on Thursday as a proposed revision in Japan's public pension fund's strategy is expected to boost equity markets and undermine the Japanese currency.
Sources told Reuters the Government Pension Investment Fund (GPIF) was considering a more flexible approach to allocations which could let investment in domestic stocks grow in rallying markets.
Given the recent negative correlation between equities and the yen, which tends to benefit during periods of financial stress, traders said the news pushed Nikkei equity futures higher and caused the yen to reverse earlier gains.
The dollar rose 0.5 percent on the day to 101.67 yen, recovering from an earlier trough of 100.46 yen, which was its lowest level since May 9.
"The rationale behind the yen selling on the back of Japan's GPIF headlines seems linked the hedging behaviour of foreign investors buying Japanese stocks," said Valentin Marinov, head of European G10 FX strategy at Citi.
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"If the headline is confirmed, it could fuel a renewed Nikkei rally and hence more demand for short-yen hedges by foreign investors. This could trigger more dollar/yen buying from here."
The yen is impacted when foreign investors buy Japanese equities because they hedge this investment by buying dollars against the yen.
The dollar had earlier slipped against yen on Thursday after faltering equities pushed market participants to opt for the safety of the yen and unwind their bets for a stronger dollar.
Most market participants expect the dollar to continue to gain against the yen over the medium term due to the Bank of Japan's aggressive monetary easing and that buyers would emerge on dips.
The euro was also up 0.6 percent against the yen at 131.67 yen.
Against the dollar, the euro was up 0.1 percent at $1.2952 after briefly breaking the $1.30 mark to hit a peak of $1.3006.
The single currency was also supported by data which signalled an improvement in economic sentiment in the euro zone.
But strategists said there was still a chance of a rate cut by the European Central Bank and this could hurt the euro.
"If euro area economy deteriorates people will take a closer look at the likelihood the ECB will cut rates and that will drive the euro lower," said Paul Robson, currency strategist at RBS.
Strategists also said the dollar would find support on prospects the U.S. Federal Reserve might taper its current $85 billion-a-month stimulus programme in coming months.
"Quantitative easing tapering cannot be ruled out later this year and that is going to continue to support the dollar... we won't see a trend reversal lower in the dollar," Citi's Marinov said.
(Editing by Toby Chopra)