Dollar higher as markets parse fragile Middle East peace talks

By Hannah Lang

NEW YORK, June 1 (Reuters) - The U.S. dollar was higher on Monday after a small weekly loss as investors digested fresh developments in Middle East peace talks after the U.S. and Iran traded blows over the weekend, raising questions about the fragility of diplomatic efforts to end the war.

The dollar index, which measures the currency against six peers, edged lower last week on expectations that a deal between the U.S. and Iran to reopen the Strait of Hormuz was close. The closure of the key oil artery has lifted oil prices and worsened the inflation outlook, leading some observers to expect the Federal Reserve would raise rates this year.

The dollar edged higher on Monday after Iran's Tasnim news agency said Tehran's negotiating team is stopping exchanges of messages with the U.S. through mediators due to attacks on Lebanon. Later in the day, U.S. President Donald Trump said he spoke with Iran-aligned Lebanese militia group Hezbollah through intermediaries ​and secured a pledge that it would not attack Israel, paring some of the dollar's gains.

The dollar index was last up 0.184% at 99.195 after last week's drop of 0.4%.

The greenback had rallied at the onset of the conflict, which began on February 28, buoyed by safe-haven demand and the U.S. economy's relatively limited exposure to energy-driven inflation. However, it has given back some of those gains due to uncertainty surrounding the conflict's trajectory.

The euro was down 0.26% at $1.1632, while sterling was 0.03% higher at $1.34565.

Should the Strait of Hormuz reopen to traffic and oil prices fall, the dollar would likely weaken in the near term and risk-sensitive currencies, such as the Swedish crown, would outperform, said Tommy von Bromsen, FX strategist at Handelsbanken. 

But currency markets are in wait-and-see mode after the U.S. military said it had over the weekend struck Iranian air defences, a ground control station and two drones that were threatening ships after "aggressive Iranian actions," ​including the shooting down of a U.S. drone over international waters.

Iran's Islamic Revolutionary Guard Corps said on Monday it had targeted an air base used by the U.S. in response to an attack on southern Iran.

FED WATCH

Markets are betting the U.S. central bank's next move will be to raise its benchmark interest rate, compared with expectations for a cut before the start of the Iran war, given rising energy prices and the impact they will have on inflation, and a still-resilient jobs market. 

The release on Friday of the monthly U.S. employment report could help sway what the Fed will do in the near term. The data are expected to show a gain of 85,000 jobs in May and no change in the current 4.3% unemployment rate, according to a Reuters poll of economists.

Fed Governor Jerome Powell, whose term as head of the central bank formally ended last month, warned in a speech on Sunday about politicization of monetary policy. Powell has decided to remain on the Fed's Board of Governors in part because of what he regards as ongoing threats to the central bank's independence.

YEN IN FOCUS

Markets are highly anticipating a speech by Bank of Japan Governor Kazuo Ueda on Wednesday for possible signals as to whether the central bank will proceed with a rate increase the following week.

While there is no consensus yet within the BOJ on the decision, a pause in the central bank's taper of government bond purchases is increasingly seen as a preferred option, two sources familiar with the deliberations said.

The yen weakened 0.28% to 159.710 per dollar, close to the psychologically important 160 level that saw intervention by Japanese authorities to strengthen the currency.

"It seems like 160 is where they draw the line," said Handelsbanken's von Bromsen. "I think there will be intervention if we approach that level again."

The Australian dollar traded 0.29% lower at $0.7161 against the dollar, while New Zealand's kiwi slid 0.9% to $0.59365.

(Reporting by Hannah Lang in New York and Samuel Indyk; additional reporting by Rocky Swift; Editing by Shri Navaratnam, Chizu Nomiyama, Paul Simao and Daniel Wallis)