Dollar holds firm as markets sniff risks of Fed hawkishness

LONDON (Reuters) - The dollar held firm on Wednesday after a surprisingly high reading for U.S. inflation raised expectations that Federal Reserve Chair Janet Yellen could strike a more hawkish tone on the monetary policy outlook.

The risk of a faster U.S. policy tightening was high enough to keep European stocks on the defensive, following earlier falls in many Asian markets. Euro zone bonds sold off slightly.

Sterling < GBP=D4> traded near its recent five-year peak of just over $1.70 before the Bank of England releases the minutes of its last policy meeting. BoE Governor Mark Carney said last week rates might rise before many were predicting, fuelling expectations for a first UK rate hike later this year.

The U.S. and British central banks' outlooks diverge from that of the European Central Bank, which cut all its interest rates earlier this month, while promising banks more liquidity. The Fed's two-day meeting ends later on Wednesday and is followed by a news conference with Yellen.

"Markets have been on a hair trigger going into this FOMC meeting partly because of the recent changes of tone from the BoE and ECB. That will mean markets will be reading even more into every word Yellen says than before," said Aberdeen Asset Management Investment Manager Luke Bartholomew.

"If the Fed is more hawkish then the message will be one of divergence from the ECB and the euro will suffer. If the Fed is neutral or dovish then markets will see them as diverging from the Bank of England and so sterling will benefit."

The dollar index last stood at 80.613 <.DXY>, having climbed 0.2 percent on Tuesday. Against the yen, the greenback reached a one-week high of 102.31 , while the euro retreated from a one-week peak hit on Tuesday to trade flat at $1.3550 . [FRX/]

U.S. consumer prices recorded their fastest rise in more than a year and it may give the Fed a reason to signal it could bring forward the date when it might consider hiking rates.

"We had this number yesterday and it's probably too early to say if it's a trend but certainly... it's sign that pressures are starting to pick up a bit," said Kenneth Broux, a strategist at Societe Generale.

The FTSEurofirst 300 <.FTEU3> index of top European shares was up 0.2 percent at 1391.10. [.EU]

DIVERGING OUTLOOKS

German 10-year Bund yields , the benchmark for euro zone borrowing costs, rose 1 basis point to 1.42 percent. The yield premium offered by U.S. Treasuries over Bunds was around its highest since 2005 at 125 bps, highlighting the diverging economic and monetary policy outlooks.

The ECB's stance has kept yields on top-rated bonds depressed and pushed investors towards riskier assets aiming to maximize returns. Cyprus was on the verge of making the fastest comeback to markets of any bailed-out euro zone country with a new five-year bond on Wednesday. [GVD/EUR]

The looming Fed meeting sent ripples all over the world, with emerging market currencies falling on concerns that higher U.S. yields would make investments in these countries less attractive and potentially hinder their growth prospects.

The Indonesian rupiah hit a four-month low, while Thailand's baht , the Malaysian ringgit and the Philipine peso also fell. Emerging Europe's currencies also held close to multi-month lows to the dollar.

In other markets, Brent crude held above $113 per barrel as heavy fighting in Iraq shut the country's biggest refinery and led to the withdrawal of staff from foreign oil firms.

(Reporting by Marius Zaharia; Editing by Toby Chopra)

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