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Dollar holds firm as markets sniff risks of Fed hawkishness

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[June 18, 2014]  By Marius Zaharia

LONDON (Reuters) - The dollar held firm on Wednesday after a surprisingly high reading for U.S. inflation raised expectations that Federal Reserve Chair Janet Yellen could strike a more hawkish tone on the monetary policy outlook.

The risk of a faster U.S. policy tightening was high enough to keep European stocks from hitting new multi-year highs. U.S. stocks futures <ESc1> indicated a slightly positive opening on Wall Street.

The U.S. and British central banks' outlooks diverge from that of the European Central Bank, which cut all its interest rates this month and promised banks more liquidity. The Fed's two-day meeting ends later on Wednesday and will be followed by a news conference with Yellen.

"There's lots of attention on the inflation number," said Investec chief economist Philip Shaw. "Investors are probably being a bit cautious and being positioned for Yellen to say it's a bit of a concern that inflation surprised on the upside."

"Certainly the days when the Fed was talking about inflation being too low have passed. But whether they express concern, that's another matter."

The dollar index was little changed at 80.58 <.DXY>, having climbed 0.2 percent on Tuesday. Against the yen, the greenback reached a one-week high of 102.31, while the euro retreated from a one-week peak to trade at $1.3566.

"If the Fed is more hawkish then the message will be one of divergence from the ECB and the euro will suffer," said Aberdeen Asset Management investment manager Luke Bartholomew. "If the Fed is neutral or dovish then markets will see them as diverging from the Bank of England and so sterling will benefit."

The FTSEurofirst 300 <.FTEU3> index of top European shares was up 0.12 percent at 1,389.46.

Sterling retreated from five-year highs to trade 0.11 percent down on the day at $1.6946 after the minutes of the Bank of England's last meeting.

Backing comments last week from Governor Mark Carney that sent the pound soaring, the bank's nine-strong policy committee said it was surprised that markets had priced in a relatively low chance of an interest rate rise in 2014.

But the meeting took place before data, on Tuesday, showing inflation slid to a new five-year low. Members also agreed that, in the absence of inflationary pressures, it would be necessary to see more evidence of economic slack being absorbed before raising rates, the minutes showed.

"This was...an unsurprising set of minutes which did however paint a picture of a committee which is becoming increasingly divided about the appropriate time for tightening," said Nick Beecroft, senior market analyst at Saxo Capital Markets.

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The yield premium offered by U.S.Treasuries over German Bunds was around its highest since 2005 at 125 basis points, highlighting the diverging economic and monetary policy outlooks.

The ECB's stance has kept yields on top-rated bonds depressed and pushed investors towards riskier assets, aiming to maximise returns. Cyprus was on the verge of making the fastest comeback to markets of any bailed-out euro zone country with a new five-year bond on Wednesday.

"We put in a bid not because Cyprus is the soundest creditor in the world but because there's a hunt for yield going on and the bonds will perform," said Guido Barthels, CIO at Luxembourg-based Ethenea.

The looming Fed meeting sent ripples all over the world, with emerging market currencies falling on concerns that higher U.S. yields would make investments in these countries relatively less attractive and potentially hinder their growth prospects.

The Indonesian rupiah hit a four-month low, while Thailand's baht, the Malaysian ringgit and the Philipine peso also fell. Emerging Europe's currencies also held close to multi-month lows to the dollar.

In other markets, Brent crude oil <LCOc1> neared $114 per barrel as a strike by Sunni militants on a key refinery near Baghdad stoked worries about oil exports from key producer Iraq.

(Additional reporting by Francesco Canepa and Patrick Graham; Editing by Hugh Lawson)

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