FILE PHOTO: U.S. dollar banknotes are seen in this illustration taken March 19, 2025. REUTERS/Dado Ruvic/Illustration/File Photo

By Jaspreet Kalra

MUMBAI (Reuters) -Sterling and the Japanese yen slumped on Tuesday on the back of growing investor anxiety about government finances, allowing the dollar to claw back some ground after five days of selling.

Renewed pressure on bond markets, with Britain's 30-year borrowing costs rising to their highest levels since 1998, spilled over into currency markets, while gold hit fresh record highs.

Sterling fell 1.3% to $1.3379, its lowest level since August 7, while the dollar firmed by 1% to 148.66 yen.

The euro gained against both sterling and yen by 0.6% and 0.3%, respectively.

While sterling was weighed down by lingering worries over Britain's fiscal position ahead of a budget later this year, dovish-leaning remarks from a Bank of Japan official and the resignation of a key ruling party official pulled down the yen.

"Sterling's underperformance is reflecting the growing concerns over the fiscal situation as we move closer to the budget and it becomes a bigger focus for market participants," said Lee Hardman, senior currency analyst at MUFG.

Finance minister Rachel Reeves is expected to raise taxes in her autumn budget in order to remain on course for her fiscal targets, potentially adding to the challenge of boosting growth.

For the Japanese yen, heightened political uncertainty was likely to remain a drag, while the lack of a hawkish policy signal from Deputy Governor Ryozo Himino on Tuesday would encourage speculators to continue rebuilding short yen positions, Hardman said.

The dollar also drew support from an uptick in U.S. Treasury yields as investors home in on key U.S. labour market data due this week for cues on the path of benchmark interest rates.

Against a basket of major currencies, the dollar was up 0.8% at 98.4.

The interest rate expectations-sensitive 2-year U.S. Treasury yield was up 3 bps at around 3.653% after hitting its lowest level since May last week. U.S. markets were shut on Monday for the Labor Day holiday.

Money markets are currently pricing in a 91% chance that the Fed will cut rates by 25 basis points this month, but those wagers could be tested by U.S. economic data lined up this week.

Data due this week include ISM's manufacturing and services purchasing managers' indexes and the non-farm payrolls report.

While the data was likely to cement expectations of a rate cut by the Fed, it was unlikely to cause a sharp move lower in the dollar beyond the knee-jerk reaction, said Jane Foley, head of FX strategy at Rabobank.

The bank expected the euro to rise to $1.20, but the move was more likely to be a grind higher than a bounce and was likely to roughly coincide with the end of Fed Chair Jerome Powell’s term in the spring of next year, Foley said.

Concerns about the independence of the U.S. Federal Reserve have also been in focus for investors in light of U.S. President Donald Trump's repeated push for lower policy rates and his move to fire Fed Governor Lisa Cook over allegations of mortgage fraud, which she denies.

Elsewhere, data released on Friday showed that Euro zone inflation edged up in August but remained close to the European Central Bank's 2% target, likely reinforcing market expectations that the ECB will keep benchmark rates unchanged in the near-term.

Spot gold, meanwhile, steadied after touching an all-time high and was last up 0.2% at $3,483 per troy ounce.

(Reporting by Jaspreet Kalra; Editing by Ros Russell and Alex Richardson)