NEW YORK (Reuters) — The dollar hit a record low against the euro and 26-year troughs against sterling yesterday, as investors fretted about a possible fallout from weakness in the US subprime mortgage market.The dollar also slumped nearly one percent against the yen, as risk-averse investors cut back on "carry trade" transactions funded by borrowing in the Japanese currency.

In carry trades, investors borrow in a low-yielding currency such as the yen to buy higher-yielding units such as the dollar.

"This is a combination of unwinding of carry trades and broad dollar weakness, mainly because of what S&P did," said Ashraf Laidi, chief currency analyst, at CMC Markets in New York.

Yesterday, Standard & Poor's said it may cut 612 residential mortgage-backed securities backed by US subprime loans, affecting $12 billion in debt. Subprime loans are extended to borrowers with poor credit.

The subprime news pushed down US stocks, bond yields and the dollar across the board.

The euro rose to $1.3741 against the dollar, a record high, according to electronic trading platform EBS, before falling back to $1.3713, still up 0.6 percent on the day.

Sterling climbed to around $2.0274 against the dollar, its highest in 26 years according to Reuters data. The British pound last traded at $2.0243, up 0.5 percent from late on Monday.

Against a basket of major currencies, the dollar fell to a 2-[1/2] year low around 80.822.

CMC's Laidi said market developments have become interesting as Federal Reserve Chairman Ben Bernanke prepares to reiterate the US central bank's mission of fighting inflation as weakness in the housing sector hits corporate earnings.

Bernanke was scheduled to talk about inflation later in the session, with some analysts speculating that he could comment on the troubled subprime sector.

Against the yen, the dollar fell 0.9 percent to 122.24 , on track for its steepest fall since mid-March. The high-yielding Australian and New Zealand dollars dropped 0.7 percent against the yen to 105.29and 94.91 respectively.

Analysts also said the dollar's dwindling interest rate advantage over other currencies has hurt the greenback. Benchmark U.S. rates have held at 5.25 percent for more than a year, reducing the dollar's appeal to global investors when other major central banks such as the European Central Bank are raising rates.

The ECB is expected to hike rates again in September to 4.25 percent, with some economists betting on a follow-up quarter-point hike to 4.5 percent by the end of the year.

The Bank of Canada, meanwhile, raised interest rates to 4.50 percent earlier on Tuesday. The US dollar rose 0.2 percent against the Canadian dollar to C$1.0514, benefiting from the Canadian central bank's less hawkish monetary policy statement.

"It's still an interest rate differential game," said Gregory Salvaggio, a vice-president for trading at Tempus Consulting in Washington.

"The ECB is going to hike rates at least two times more this year and US bond yields are falling, giving no incentive for large global investors to hold dollars," he added.

Lower US bond yields arising from problems in the subprime sector have diminished the allure of US Treasury debt. The yield on the benchmark 10-year US Treasury note yesterday was at 5.08 percent, down from about 5.29 about a month ago.