NEW YORK (Bloomberg) — The yen rebounded from a four-year low versus the dollar this week as European officials said Japan’s currency is undervalued.The currency had its first weekly gain versus the dollar in about a month as US Treasury Secretary Henry Paulson said he was watching the yen “very carefully”. Investors bought yen before next week’s Group of Seven meeting on speculation members would discuss the currency’s recent decline. The Japanese currency has weakened 1.7 percent against the dollar this year.

“Investors pared back their extreme short yen positions ahead of the G-7 meeting,” said Brian Garvey, senior currency strategist with State Street Global Markets in Boston, one of the world’s largest custodians of investor assets with $10.7 trillion. The yen also “gained partly because foreign investors started buying Japanese equities fairly aggressively”.

The yen strengthened to 121.13 per dollar on Friday from 121.54 on January 26, and 157.01 per euro from 156.99. The dollar traded at $1.2961 per euro from $1.2916. The Japanese currency gained 0.3 percent this week against the dollar.

The Brazilian real this week was the best performing major currency tracked by Bloomberg, gaining 1.6 percent versus the US dollar. New Zealand’s dollar was the worst performer, declining 2.2 percent.

The Nikkei 225 Index rose 0.7 percent this week to 17,547.11.

Officials from France and Germany this week said the yen’s value doesn’t reflect economic fundamentals, suggesting they’ll seek a stronger currency at the February 9-10 meeting of the G-7.

European Central Bank board member Christian Noyer said the yen’s value doesn’t reflect the strength of the Japanese economy, the Nikkei newspaper reported.

The yen’s gain may be reversed on prospects the Bank of Japan will raise rates gradually, encouraging investors to borrow the Japanese currency to buy higher-yielding assets abroad, in a practice known as carry trade.

The BOJ’s benchmark interest rate is 0.25 percent, while the European Central Bank’s refinancing rate is 3.5 percent and US borrowing costs were left unchanged this week at 5.25 percent.

Contracts for the exchange of interest payments showed 42 percent odds of a quarter-percentage point increase to 0.5 percent at the February 20-21 BOJ meeting, according to Credit Suisse Group calculations. They were 69 percent after the last meeting on January 18.

Implied volatility on one-month dollar-yen options rose to as much as 8.28 percent on February 1, the highest in more than four months. Traders quote implied volatility, a measure of expected price swings, as part of setting options prices.

Hedge funds and other large speculators placed a record amount of bets the yen will decline against the dollar, according to weekly data from the Washington-based US Commodity Futures Trading Commission.

The difference in the number of wagers on a decline in the yen compared with those on a gain — so-called net shorts — jumped to a record 173,005 on January 30, trumping the prior record of 164,860 a week earlier.

“The short positions in the yen were so large that people have to take some risk away,” said Peter Frank, senior currency strategist at ABN Amro Bank NV in London.