By Ankur Banerjee and Harry Robertson
SINGAPORE/LONDON, Aug 18 (Reuters) - The U.S. dollar rose slightly on Tuesday but remained near multi-month lows against its peers as traders reduced their bets on rate hikes, although the threat of an escalation in the Middle East war left sentiment fragile.
The euro eased away from two-month highs of $1.161 touched on Monday and was last little changed at $1.157.
Sterling was at $1.352, dipping 0.1% on weak UK labour market data, just shy of the three-month peak
it hit in the previous session.
Data in the past few weeks have pointed to a softer U.S. economy, including unexpected job losses last month and mild inflation readings, leading investors to scale back expectations of a rate hike by the U.S. Federal Reserve.
INFLATION ANGST
By contrast to the currency markets, bond traders were much more focused on concerns about inflation stemming from the Middle East war as well as on increased fiscal pressures. Long-term borrowing costs for major Western economies were at their highest levels in decades on Tuesday.
Joint U.S. and Japanese intervention to strengthen the yen in late July has also weighed on the dollar more broadly.
Traders expect a 35% chance of a rate increase at the Fed's September meeting, compared with 52% a week ago, according to the CME FedWatch tool. They are also no longer fully pricing in a hike by the end of the year.
Yet analysts remain cautious about where inflation may head, with the critical Strait of Hormuz remaining effectively shut and the U.S.-Iran conflict simmering.
"Inflation has been above target for most of the past five years, and whilst a high 2% annual pace may prove acceptable to the Fed, it leaves the inflation process with little to no breathing room in a world of constant supply shocks," said Nohshad Shah, head of EMEA fixed income sales at Citadel Securities.
Iran said it would shift to a "fully offensive" military posture because efforts to negotiate a permanent end to the war have stalled, a senior Iranian official told Reuters as Washington ruled out extending their June ceasefire agreement.
The more than five-month-long conflict has stoked inflationary concerns and upended the global interest rate outlook.
Rising worries on Tuesday helped crimp some of the dollar's losses through safe-haven flows, with the dollar index, which measures the U.S. currency against its peers, trading 0.1% higher at 99.62.
The Japanese yen was a touch weaker at 159.70 per dollar, having erased nearly half of the gains from the joint U.S. and Japan intervention at the end of July to lift the fragile yen away from a 40-year low of 163.99.
Traders are focused on the threat of more intervention as well as the Bank of Japan meeting next month, where the central bank is set to raise interest rates and is considering hiking more aggressively after that, sources told Reuters.
BONDS SELL OFF ON OIL AND BORROWING CONCERNS
Meanwhile, bond yields around the world were on the rise again, partly due to traders' concerns about the impact on energy prices of a prolonged closure of the Strait of Hormuz. [US/]
Brent crude futures rose 0.2% to $91.10 a barrel, touching their firmest levels since July 30. [O/R]
U.S. 30-year Treasury yields rose to their highest level since 2007, while yields around the world moved higher. Yields move inversely to prices.
"Bond traders appear more concerned about the longer-term inflation outlook than currency traders at present," said Matt Simpson, senior markets analyst at StoneX.
"If bond markets are right — and they have an annoying tendency to be — the U.S. dollar's pullback may prove short lived."
The spotlight has also been on recent U.S. Treasury auctions for the multi-decade yields demanded by investors to absorb Washington's borrowing needs.
(Reporting by Ankur Banerjee in Singapore and Harry Robertson in London; Editing by Sonali Paul and Gareth Jones)
