Dollar holds near 10-week low ahead of inflation report

© Reuters. FILE PHOTO: A picture illustration shows U.S. 100-dollar bank notes taken in Tokyo August 2, 2011. REUTERS/Yuriko Nakao

By Kate Duguid

NEW YORK (Reuters) -The U.S. dollar hit a 2-1/2-month low early in the New York session, then stabilized around those levels on Tuesday afternoon, the eve of U.S. consumer price data, as investors bet that rising inflation could erode the currency's value.

In recent years, rising inflation expectations have helped the dollar because investors assumed the Federal Reserve would hike interest rates in response to higher prices. That is no longer the case.

A disappointing employment report last week triggered a widespread selloff in the greenback. And though surging commodity prices have raised concerns of higher inflation, markets believe the Fed will keep its commitment to low rates and hefty asset purchases.

"People are fearful that the Fed means what they say. And what they're saying is - we're not going to raise rates, but also we're going to let inflation run," said Andy Brenner, head of international fixed income at NatAlliance Securities.

Against a basket of its major rivals, the dollar dropped as low as 89.979, its lowest since Feb. 25, and was last down 0.11% at 90.138.

"Even if we see a print above expectations tomorrow, the likelihood of a robust dollar rally is very much lessened by the fact that far fewer market participants expect the Fed to react to that number in any way," said Karl Schamotta, chief market strategist at Cambridge Global Payments (NYSE:GPN).

The dollar index's dip under 90 - the first time it fallen below that level since Feb. 25 - appeared to have prompted some investors to cover short dollar positions as major currencies subsequently pulled back, said a note from Action Economics.

Resource-oriented currencies, including the Canadian dollar, consolidated gains as a rally in commodity prices boosted their appeal. The loonie hit a 3-1/2 year high and was last 0.08% higher at C$1.209.

"The economy is performing quite strongly, so that is supporting expectations for the Bank of Canada to hike ahead of the Fed," said Karl Schamotta, chief market strategist at Cambridge Global Payments.

"Friday's (U.S.) employment data helped entrench the interest-rate differential between the two currencies, so that's lifting it. But the biggest impact by far is the rise in base metal prices."

The euro hit a 2-1/2-month high during the session and was last up 0.21% at $1.215.

In cryptocurrencies, ether dipped from record levels hit on Monday, but remained up 2.60% on the day to $4,057. The second-biggest digital token has rallied roughly 46% so far in May.