Bernanke stokes Fed rate hike outlook

The dollar jumped to a three-month high against the yen on Tuesday after Federal Reserve Chairman Ben Bernanke said the central bank would strongly resist an erosion in inflation expectations, convincing more investors that rate hikes could come this year.

Bernanke also said the latest surge in energy prices is adding to the dangers from inflation and that the risk of a substantial downturn in the US economy has receded, sparking broad dollar gains and sending US bond yields soaring.

Such comments by the Fed chief, along with European Central Bank officials signalling that an interest rate increase could come as soon as next month, show top central bankers are trying to limit the inflation impact from oil spiking to near $140 a barrel.

The array of inflation-fighting comments from Bernanke followed an unexpected barrage of remarks from US officials saying they are keeping an eye on the dollar while keeping open the option of dollar-buying intervention to stem its slide.

"They're trying to stop the dollar from going down. They obviously think that if the dollar goes lower, it will push commodity prices higher," said Rick Lloyd, head of G10 currency trading at ABN AMRO in Singapore.

The dollar tends to slide when oil prices climb, partly due to expectations that oil producers will shift some of their dollar-denominated windfall into other currencies. Oil was near $135 on Tuesday.

US Treasury Secretary Paulson declined on Monday to rule out intervention in the foreign exchange market to stabilise the dollar.

Paulson's words resonated with investors after Bernanke took many investors by surprise last week by saying a weaker dollar was adding to inflation risks - unusually blunt comments about the currency from a Fed chief that stoked speculation about intervention.

Highlighting the sudden shift in expectations on the Fed policy outlook, the two-year US Treasury yield soared as much as 25 basis points on Tuesday to high of 2.966 per cent - nearly a full percentage point above the current 2 per cent fed funds rate.

Higher US interest rates tend to boost the dollar, which has tumbled to record lows against the euro and a basket of currencies this year as the Fed aggressively chopped rates to stem the economic fallout from the housing market troubles.

"Bernanke sounded clearly like a strong inflation fighter," says a senior FX trader at a Japanese bank.

The dollar climbed 0.4 per cent from late US trade to 106.75 yen and struck a three-month peak of 106.83 yen.

The euro shed 0.4 per cent to $1.5573 and dropped as far as $1.5558, a sharp reversal from a six-week peak of $1.5844 struck on Monday.

Against a basket of currencies, the dollar was up 0.4 percent at 73.167, pushing back towards a one-month peak of 73.87 struck last week.

The euro had shot higher last week after ECB President Jean-Claude Trichet said a number of policymakers wanted higher rates and a hike from 4 per cent was possible next month - a message he took pains to repeat on Monday.

The flagging of a possible near-term ECB rate hike has slammed short-term euro zone bonds in a sell-off that spilled into the US and Japanese government bond markets.

Along with the slide in Treasuries after Bernanke's speech, the JGB two-year yield soared 13.5 basis points to 0.980 per cent and hit a 10-month peak, even as many analysts remain doubtful about a Bank of Japan rate increase.

"The economy is of primary concern in Japan, and the BOJ will not be able to hike rates as long as downside risks to the economy remain," said Tomoko Fujii, head of Japan strategy and economics at Bank of America.