FOREX-Dollar steps back from 3-1/2 month highs as yields stabilise

The index that measures the dollar's strength against a basket of other currencies was 0.2% lower in early deals in London, at 92.181, after hitting a 3-1/2 month high of 92.506 during Asian trading hours. U.S. 10-year Treasury yields fell as low as 1.5350% , down for a second day.

Traders are wary yields could rise further this week as the market will have to digest a $120 billion auction of 3-, 10-, and 30-year Treasuries, especially after last week's soft auction and a 7-year note sale that saw a spike in yields. "Stability is likely to remain the theme of the day ahead of the UST auctions and the US inflation release tomorrow, which are the near-term risks for FX markets (given the possible negative spillover into USTs and the risk of a further sell off)," said ING strategists Chris Turner, Francesco Pesole and Petr Krpata in a daily note.

"Near-term, the currencies of oil exporters should be favoured over low yielders in the G10 FX space, with the rising oil price providing an offsetting factor to the challenging global risk environment." The Norwegian crown, an oil-linked currency, gained 0.6% to 8.4898 per dollar. Oil prices have climbed in recent days on expectations of a recovery in the global economy and on a likely drawdown in crude oil inventories in the United States, the world's biggest fuel consumer. They shot up on Monday after an attack on a Saudi Arabian oil export facility.

The Australian dollar gained 0.7% to $0.7695. and the New Zealand dollar gained 0.5% to $0.7149. The euro traded 0.3% higher at $1.18845 and sterling gained 0.5% to $1.3886, both currencies benefiting as the dollar took a breather.

The dollar index has firmed more than 2% year-to-date, as upbeat macroeconomic data, combined with accommodative monetary policy, has lifted bond yields and hit highly valued U.S. technology stocks. The greenback's rise comes in the face of broadly bearish forecasts laid out at the start of this year. Analysts at BCA Research put the currency's gains down to three reasons.

"First, the dollar was very much oversold, with net speculative positioning heavily short and sentiment close to a bearish nadir. As such, a rebalancing in positioning was to be expected." "Second, the rise in U.S. interest rates has increased the appeal of the USD, particularly against currencies such as the euro and the yen. Finally, and on a related note, economic momentum has been improving in the US of late, compared to other G10 countries," they said in a note to clients.

All eyes will now be on the U.S. Federal Reserve's two-day meeting next week, although expectations are low that the central bank will announce major policy changes after Chair Jerome Powell last week did not express concern about the rise in bond yields.