Dollar hovers near three month highs as traders gauge rates outlook

The dollar fell slightly on Thursday but remained near three-month highs after a surprise rate hike from the Bank of Canada suggested other central banks, including the Federal Reserve, may have more work to do to combat inflation.

The euro EURUSD was up 0.1% at $1.071 early in the European session against the dollar - the most traded currency pair in global markets.

That helped push the dollar index DXY, which measures the currency against six major peers, down very slightly to 104. It remained close to last week's peak of 104.7, however, which was the highest since March 15.

The dollar had been on the back foot on Wednesday but jolted higher against the euro and Japan's yen after the Bank of Canada surprised traders by raising interest rates to 4.75%. It followed a rate hike by the Reserve Bank of Australia on Tuesday.

"The view here was that if both Australia and Canada felt the need for further hikes, in all probability the Fed would too," Chris Turner, head of markets at ING, said in a note to clients, referring to the U.S. Federal Reserve.

Against Canada's dollar USDCAD, the U.S. dollar was down 0.16% at C$1.335, after falling 0.24% on Wednesday.

The Australian dollar AUDUSD was up 0.43% at $0.668, taking its monthly gains to roughly 2.7%. Sterling GBPUSD was 0.1% higher at $1.245.

The Canadian decision put the spotlight back on the Federal Reserve, which sets interest rates on Wednesday next week.

According to derivative market pricing, traders currently think there's a 70% chance the Fed holds rates next week, and a 30% chance of a 25 basis point (bp) increase.

They think the Fed could then raise rates by 25 bps in July, after policymakers hinted at a so-called skip. That would boost the Fed funds rate to a range of 5.25% to 5%.

The European Central Bank sets rates on Thursday and traders broadly expect a 25 bp hike, to be followed by another 25 bp increase in July, taking rates to 3.75%.

In Asia, the dollar was down 0.29% against Japan's yen USDJPY at 139.76 yen per dollar, after rising 0.37% the previous day.

The onshore USDCNY and offshore yuan USDCNH eased to their weakest in six months against the dollar, further pressured by economic worries.

Data released on Wednesday showed China's exports shrank much faster than expected in May while imports extended declines, raising doubts about the country's fragile economic recovery.

"To some extent, it's a view that the trade data's another symptom of a faltering recovery," said Ray Attrill, head of FX strategy at National Australia Bank.

Meanwhile, the Turkish lira USDTRY slipped to a record low of 23.39 per dollar in early Asia trading. It remained under pressure, last at 23.37.