Dollar turns slightly defensive, inflation data next key test

The dollar turned defensive against other major currencies on Tuesday, with traders reluctant to push the greenback higher without further signs that another aggressive interest rate hikes from the Federal Reserve was coming in September.

US inflation data on Wednesday was shaping up as the next key test for the dollar, which rose sharply after Friday's unexpectedly strong jobs report fuelled bets on another 75 bps Fed rate hike.

But the currency has pulled back since and in thin summer markets, succumbed to some mild selling pressure on Tuesday.

At 1050 GMT, the euro was up around 0.35% at $1.0226 , sterling gained 0.2% to $1.2102 , while the dollar slipped 0.1% to 134.86 yen.

That left the dollar index , which measures the currency's value against a basket of other peers, 0.2% lower at 106.15. It held below a more than one-week peak hit on Friday at 106.93.

"I'm a bit concerned about inflation tomorrow. The market has been wrong-footed all year and if we get a strong core inflation print that will nail expectations for a 75 bps rate hike in September," said Kenneth Broux, a currency strategist at Societe Generale in London.

"It's too soon to say it's time to short the dollar as the Fed may have to do more."

The Fed hiked rates by a hefty 75 bps in June and July. Money-market futures show traders see about a two-thirds chance of a 75 bps hike next month and have started pushing expectations for rate cuts deeper into 2023.

Economists polled by Reuters see year-on-year headline inflation at 8.7% - incredibly high, but below last month's 9.1% figure. The Fed targets inflation at 2%.

Heightened expectations for aggressive near-term hikes, have pushed short-dated Treasury yields further above long-term peers.

The gap between two and 10-year Treasury yields , a reliable recession indicator, has grown to its largest in two decades.

"The US yield curve is inverted, suggesting recession down the line. But equity markets look as if they believe the Fed is going to stop soon and start cutting in 2023," said Mizuho senior economist Colin Asher.

"I think tomorrow's CPI data will suggest the Fed is not going to stop, which to me suggests weaker equity markets ahead which will limit any dip in the dollar in the next few months."

The dollar's haven status, though, makes the greenback's reaction a little harder to predict, especially as growth and geopolitical worries swirl.

China extended military drills near Taiwan, and the self-ruled island's foreign minister said China was using the drills launched in protest against US House Speaker Nancy Pelosi's visit as an excuse to prepare for an invasion.