SAN FRANCISCO (MarketWatch) -- The dollar soared against the euro and the British pound Wednesday, pressured by further fund repatriation and expectations the European Central Bank and the Bank of England will move to aggressively cut interest rates in coming months.

But the greenback slipped against the yen, which also gained on the pound and euro as another sell-off on Wall Street fanned risk aversion.

U.S. stocks ended sharply lower, with the Dow industrials down more than 500 points. See Market Snapshot.

"Deleveraging and risk aversion have been the primary catalysts for the strength in the low yielders (U.S. dollar and Japanese Yen), but currency bets gone wrong, repatriation and the fears of weak growth in Europe have also fueled the rally," wrote Kathy Lien, director of currency research at GFT.

The yen, which has been the ultimate risk-aversion currency during recent financial turmoil, posted broad gains.

"Investors continue to flock to the dollar as speculation mounts that central banks elsewhere will continue with aggressive rate cuts in an attempt to stimulate growth in the near term," said James Hughes, analyst at CMC Markets.

The euro dropped to its lowest level against the greenback in almost two years, breaking support at $1.2800 and plunging as far as $1.2743.

"The meltdown in currency markets takes a life of its own, reflecting further deleveraging in equity and credit markets," said Ashraf Laidi, chief FX strategist at CMC.

Weakness in both the euro and the pound, he said, was intensified by worries about emerging market currencies in Eastern Europe and remarks from Bank of England Gov. Mervyn King, who said the U.K. economy is in recession.

The euro recently trimmed losses to change hands at $1.2823, still down sharply from $1.3046 in late North American trade Tuesday.

The euro also plunged against the Japanese unit to 124.58 Japanese yen, but had pared losses to 125.51 yen. It was buying 130.73 yen late Tuesday.

The pound sterling recently traded at $1.6212, down from $1.6694 late Tuesday. Earlier, it fell to a five-year low of $1.6135.

The pound plunged against the Japanese currency to 157.84. It was last buying 158.81, down 5% from Tuesday.

The dollar fell to 98.04 yen from 100.38 yen late Tuesday. Earlier Wednesday, the dollar fell as low as 97.22, its lowest level since March.

The dollar index DXY, +0.13% , a measure of the greenback against a trade-weighted basket of six major currencies, traded at 85.602, up from 84.434 late Tuesday.

Late Wednesday, the Reserve Bank of New Zealand cut its official cash rate by one percentage point, to 6.50%, as widely expected.

Emerging worries

The sharp downward pressure on the euro comes even as signs point to further stabilization of the financial sector. Instead, the focus has turned to prospects for a deep recession, pressuring the euro even though the United States and the Federal Reserve must also wrestle with a steep downturn, traders said.

"The same old reasoning still applies: The U.S. is regarded as being able to weather a recession much better than the euro zone," wrote strategists at Commerzbank.

Also, the European Central Bank has further to go in cutting interest rates than the Fed, which has already delivered the bulk of its interest-rate cuts in this cycle, they said.

"The euro is also being undermined by worries about the economies of emerging Europe," said Julian Jessop, chief international economist at Capital Economics.

Hungary's central bank on Wednesday raised its key lending rate by 3 full percentage points to 11.5% in an emergency move to defend the nation's forint currency. Read more.

The forint strengthened about 1.5% on the move, but the rebound wasn't impressive given the size of the rate hike, said Lars Christensen, chief analyst at Danske Bank in Copenhagen. He also noted the move did little to support other central European emerging currencies such as the Polish zloty and the Romanian leu.

Other countries in the region may follow suit in an effort to defend their currencies, "but we would stress that rate hikes not only have a negative impact on growth, but also on the funding costs for banks in the region, which is of course a serious problem in the present situation with a credit crunch," Christensen said in a research note.

'R' word in the U.K.

Sterling, meanwhile, fell under heavy pressure late Tuesday after Bank of England's King warned that the British economy had entered a recession.

Minutes released Wednesday from the emergency meeting of Bank of England policy makers on Oct. 8 underlined expectations for further, aggressive cuts, economists said.

The minutes showed the nine-member Monetary Policy Committee unanimously backed the decision to join other major central banks in cutting key interest rates. The central bank slashed the bank rate by a half of a percentage point on Oct. 8 to 4.5%. See full story.

Following the minutes and King's remarks, there is "very little doubt that the easing cycle will be front-loaded and the repo rate will likely be cut to 3%" by the end of the first quarter of 2009, said Chiara Corsa, economist at UniCredit MIB. "We expect the next 50 basis point rate cut in November."

Also, the pound was left particularly vulnerable by the U.K. banking sector's reliance on external capital flows to finance lending, said Naeem Wahid, currency strategist at HBOS.

"These external flows have now fallen sharply [and] unless they are replaced by other forms of external finance the adjustments in the trade deficit and the exchange rate will need to be faster than would otherwise have occurred, implying a rise in domestic saving and weakness in domestic spending in the short-run," Wahid said.

G7 volatility watch?

Volatile currency action could attract attention from Group of Seven policy makers, one strategist warned.

"Although we would not argue that the major currency pairs are substantially out of line at present ... an argument can certainly be made that the G7 members would prefer to see a sharp decline in the levels of volatility seen in the currency markets," said Simon Derrick, currency strategist at Bank of New York Mellon, in a research note.

The recent instability in currency markets could further unsettle other asset markets, Derrick said, noting sharp overnight losses in Asian equity markets.