Dollar weakens on soft US inflation data

NEW YORK/LONDON - The dollar broadly weakened on Tuesday after softer-than-expected U.S. inflation in June tempered expectations for U.S. Federal Reserve policy tightening.

However, analysts said the relief may prove temporary with the U.S.-Iran conflict pushing energy prices higher and keeping the prospects of an interest-rate hike alive later this year.

The dollar index was off 0.6% at 100.68 as Fed Chair Kevin Warsh began his first semiannual testimony to Congress.

"The softer-than-expected CPI print undercut the Fed's recent hawkish leanings, sending the dollar lower as markets pared back Fed expectations," said Uto Shinohara, senior investment strategist, at Mesirow Currency Management.

"The inflation data predates the latest rise in geopolitical tensions, higher oil prices, energy supply risks and Trump's threat of a 20% protection fee, meaning the softer headline print does not yet capture these developments."

U.S. and Iranian forces traded attacks in the Gulf, where maritime traffic through the Strait of Hormuz has come to a near-standstill, pushing oil towards $90 a barrel. As a result, investors are now pricing in a higher chance of global interest rates rising this year.

With uncertainty over how long the latest tit-for-tat exchanges might last and how they might affect the flow of oil to world markets, investors are focused on the outlook for price pressures.

Warsh said recently that anyone expecting the Fed to go soft on inflation would be "disappointed," although he stopped short of offering any guidance for what to expect in terms of monetary policy in coming months.

The odds of a July rate increase dropped to 12% from 42% yesterday, according to CME Fed Watch, although the odds of a rate hike for the year were more robust, recently at 80%, down from 89% on Monday.

Federal Reserve Governor Christopher Waller said on Monday rates may need to rise "in the near term" if data shows inflation remaining well above the central bank's 2% target.

"Fed governor Christopher Waller said yesterday,‘sternly staring at inflation until it melts before our withering gaze is not an option,' but that's exactly what seems to be playing out," said Karl Schamotta, chief market strategist, at Corpay.

"Without a sustained rise in global energy prices over the coming weeks and months, the U.S. economy is now on a modestly-disinflationary trajectory that should keep U.S. yields and the dollar capped."

The euro rose 0.66% at $1.1455, while sterling rose 0.53% to $1.3417.

Overnight currency volatility jumped, reflecting nervousness among traders. Overnight implied volatility for the euro, which reflects demand to hedge against large, immediate swings in the currency, briefly topped 10% on Tuesday, something that has rarely happened since April.

YEN VULNERABLE

The Japanese yen rose 0.34% to 161.89 per dollar on Tuesday, hovering near 40-year lows, which kept traders on alert for signs of possible official buying from Tokyo.

The Japanese currency briefly strengthened following comments from Finance Minister Satsuki Katayama that Tokyo may consider adjusting state pension fund asset allocations if the environment surrounding asset management changed sharply.

Health Minister Kenichiro Ueno told a separate press conference on Tuesday that the ministry would examine reviewing the Government Pension Investment Fund's (GPIF) asset allocation if needed, but downplayed the prospect of any near-term changes.

"In order for yen-buying pressure from a review of GPIF's asset allocation to be sustained, the decision would likely need to be made quickly, and the increases in the allocation to domestic assets would probably need to be at least 5 percentage points" in stocks and bonds each, said Masafumi Yamamoto, chief currency strategist at Mizuho Securities.

(Reporting by Laura Matthews in New York and Amanda Cooper in London; additional reporting by Satoshi Sugiyama; Editing by Thomas Derpinghaus, Kate Mayberry, Susan Fenton, Colin Barr and Sharon Singleton)

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