June 5, 2018 / 12:23 PM / 6 months ago

FOREX-Dollar heads towards 6-month highs as trade war fears rise

* Strong ISM data would seal case for a U.S. rate hike next week

* Mexican peso leads losers on trade war concerns

* Graphic: World FX rates in 2018 tmsnrt.rs/2egbfVh

By Saikat Chatterjee

LONDON, June 5 (Reuters) - The dollar on Tuesday edged towards a six-month high hit last week as the latest bout in a trade war between the U.S. and its commercial partners prompted selling in emerging market curencies, but gains were capped before a summit this weekend.

Markets were also awaiting data that might confirm the U.S. economy is on track for a strong June quarter, lifting Treasury yields as well as giving the dollar an additional boost.

"I am surprised the latest round of trade tariffs hasn't fuelled a bigger drop in other currencies as this basically signals inflationary pressures will rise in the U.S. and prompt the Fed to raise interest rates more," Commerzbank FX strategist Esther Maria Reichelt said.

Against a basket of currencies, the dollar climbed 0.1 percent at 94.13. It hit 95.02 last week, its highest since early November 2017, and has risen more than 5 percent since mid-April.

The Mexican peso and the Canadian dollar led losers against the dollar as trade war concerns rose.

Mexico said it will impose a 20-percent tariff on U.S. pork imports after U.S. President Donald Trump slapped tariffs on steel and aluminium.

The tariff was in response to the Trump administration's decision last week to impose steel and aluminum tariffs on Mexican exporters on grounds that countries including Mexico engage in competition damaging to U.S. national security.

The U.S. decision to go ahead with the steel and aluminum tariffs has complicated talks with Mexico and Canada to rework the North America Free Trade Agreement (NAFTA). I

ING strategists said in a note the latest moves by Mexico might prompt Trump to pull out of NAFTA altogether.

With correlations between short-dated U.S. bond yields and the dollar strengthening to their strongest since January 2017, investors have responded by buying the greenback in recent days, especially against the euro and emerging market currencies.

Short-dated U.S. Treasury yields are up by about 20 basis points (bps) in a week, pushing two-year government yields to 2.50 percent and within a whisker of a decade high of the 2.59 percent hit last month.

"The dollar is perched around some important levels and its strength can be judged from the fact that the euro/dollar has failed to break above the $1.17 line despite falling Italian political concerns," Societe Generale strategist Kenneth Broux said.

EURO ZONE CONCERNS

The dollar's strength was also helped by the euro's lingering weakness with latest headlines offering little evidence that Italy would stick to a path of fiscal restraint.

Bond yields rose on Tuesday, after new Italian Prime Minister Guiseppe Conte promised to bring radical change as he sought parliamentary backing for an anti-establishment government.

The euro was broadly flat at $1.16930. Since hitting a 10-month low of $1.1510 a week ago, it has recovered somewhat as investors took comfort from the formation of a coalition government in Rome.

However, market moves were muted before a Group of Seven summit starting on Friday.

The June 8 to June 9 meeting in Canada will begin with a working session on economic growth and trade - topical issues after Trump's imposing the steel and aluminium tariffs.

Strong U.S. employment data published on Friday has revived bets that the Federal Reserve will raise interest rates three more times this year. Market expectations are for two further rate hikes before until December.

A strong reading on ISM non-manufacturing PMI for May later in the day might seal the case for another rate hike at its policy meeting next week, following up on a rate hike in March and might even prompt the Fed to take a hawkish stance.

"The U.S. jobs data was really strong. The Fed could indicate it will raise rates four times this year, including an expected hike in June and one in March," Daiwa senior currency strategist Yukio Ishizuki said.

Reporting by Saikat Chatterjee; Additional reporting by Hideyuki Sano in TOKYO Editing by Louise Ireland

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