Dollar retreats as oil slumps on pause in Middle East conflict

By Medha Singh and Gregor Stuart Hunter

July 27 (Reuters) - The dollar dropped against other major currencies on Monday, as a pause in U.S. bombing in Iran dragged oil prices lower and lifted risk appetite ahead of a busy week of central bank meetings.

Against the yen, the U.S. dollar was down 0.1% at 163.645 yen, on course for its sharpest daily decline since July 10. The euro was up 0.2% at $1.130, while the pound pared early gains and eased about 0.1% to $1.331.

Oil prices sank, with Brent crude tumbling 7.5% to $89.42 per barrel after the U.S. military temporarily halted its two-week-long strikes. Tehran said it would also halt attacks if the U.S. maintained the pause, raising hopes for renewed diplomatic efforts to de-escalate the conflict.

The dollar index, which measures the U.S. currency's strength against a basket of six others, dipped 0.1% to 101.34 ahead of the Federal Reserve's July 28-29 policy meeting.

With new Fed Chair Kevin Warsh providing few clues on the policy outlook, investors have adjusted expectations for interest rates several times this month, first after a softer-than-expected consumer inflation report and then in response to an escalation in U.S.-Iran hostilities that briefly lifted crude above $100 a barrel.

Traders see a roughly 33% chance of a quarter-point Fed rate hike on Wednesday, down from 37% at the end of last week but double the probability seen a week ago, according to CME Group's FedWatch tool.

"It could be that the market is not particularly well-informed after this meeting because Warsh doesn't like to give forward guidance, and there is so much uncertainty, particularly with respect to how long the Iran war will last," said Jane Foley, head of FX strategy at Rabobank.

Bullish bets on the dollar against other major currencies climbed to their highest level since 2015, with speculators' net long positions surging to $45.37 billion in the week ended July 20, Commodity Futures Trading Commission data showed.

The Bank of England and Bank of Japan are widely expected to keep interest rates unchanged at their meetings on Thursday and Friday, respectively, while maintaining a cautious stance on inflation. 

Markets will also look to U.S. second-quarter GDP data and the Fed's preferred inflation gauge, core PCE inflation, this week for more clues on the health of the world's biggest economy. 

POLICY UNCERTAINTY 

With the yen pinned near last week's 40-year lows against the dollar, the Bank of Japan is expected to leave the door open to further hikes to arrest the currency's decline, although policymakers will likely stay ambiguous on the pace and timing of the moves. Verbal efforts to support the Japanese currency have so far yielded muted results.

"There is a sense of walking on eggshells when the Fed and Japan's authorities are prepared to be less predictable and when there is not a great understanding of what could happen next between the U.S. and Iran," wrote Paul Mackel, HSBC's global head of FX research. 

"We still side with favouring the dollar."

Sterling rose for a second session, recovering from last week's multi-week lows of $1.330 as investors looked ahead to Thursday's BoE meeting.

The central bank faces renewed inflation risks from higher oil prices, just days after new Prime Minister Andy Burnham and Finance Minister John Healey took office.

The Norwegian crown dropped 0.6% to 9.642 per dollar. The crown has been one of this month's strongest major currencies, buoyed by a rebound in oil prices that has improved the outlook for the energy-exporting economy.

In cryptocurrencies, bitcoin was up about 1% at $65,155.60, while ether climbed 2.5% to its highest since June 2 at $1,961.29.

(Reporting by Medha Singh in Bengaluru and Gregor Stuart Hunter in Singapore; Editing by Amanda Cooper, Mrigank Dhaniwala and Arun Koyyur)