LIVE MARKETS-Low inflation bets give dollar unexpected but fragile support

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LOW INFLATION BETS GIVE DOLLAR UNEXPECTED BUT FRAGILE SUPPORT

Markets are fully pricing a Federal Reserve rate hike by September, and two by March, but market gauges of short term U.S. inflation expectations remain in check below 2%.

If that's right, Commerzbank say on Monday, and they aren't sure, then that's a great set up for the dollar.

"Rising rate expectations combined with stable inflation expectations mean that the market expects higher real interest rates. This makes dollar‑denominated investments relatively more attractive," said Thu Lan Nguyen, Commerzbank's head of FX and commodity research, in a note.

The situation in Europe is different, and arguably more logical. Expectations of ECB tightening are rising, but then so are inflation expectations. That, Nguyen says, "at least partially cancels out the positive impact of higher rate expectations on the euro."

Not surprisingly, therefore euro/dollar, the world's most traded currency pair is down below $1.14, closing in on June's low of $1.325.

Of course other things are in the mix too, particularly the terms of trade shock given the U.S. and Europe's different energy supply.

And the big question is whether markets are getting that inflation pricing right in the U.S. given oil is still trading above $90 a barrel, and Brent went above $100 briefly last week.

"From my perspective, it is hard to imagine a plausible scenario in which such a pronounced increase in the oil price does not push (U.S.) inflation higher in the short term," she says.

"Low inflation expectations would ... be understandable if the market were anticipating a recession that would offset the inflationary impact of higher energy prices. At present, however, there is little evidence of this."

So what does that mean for euro/dollar? Nguyen says don't chase it lower.

"I doubt that US inflation expectations can permanently ignore a rising oil price. I would therefore not bet on EUR-USD having substantial further downside potential from here."

(Sophie Kiderlin and Alun John)

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EARLIER ON LIVE MARKETS:

STOXX UP IN BROAD-BASED RALLY, ENERGY DRAGS CLICK HERE

BEFORE THE BELL: EUROPE RISES INTO BUSIEST EARNINGS WEEK AS OIL TUMBLES CLICK HERE

MARKETS DARE TO HOPE AS US, IRAN PUT WAR ON HOLD CLICK HERE