Dollar firmer, bonds edgy as inflation adds to Fed risk

The US consumer price index increased 0.4% in May, twice the gain expected, driven in large part by rising airfares and hotel rates

The dollar climbed in tandem with rising Treasury yields on Wednesday as a surprisingly high reading for U.S. inflation threatened to give a hawkish tilt to the Federal Reserve's policy outlook later in the session.

The Fed's two-day policy meeting ends with a statement at 1800 GMT, followed half an hour later by a news conference with Chair Janet Yellen. The central bank will also provide its latest forecasts for growth, inflation and interest rates.

While economic growth has disappointed so far this year, signs of an acceleration in inflation could bring forward the day when the Fed might consider hiking rates.

The U.S. consumer price index increased 0.4 percent in May, twice the gain expected, driven in large part by rising airfares and hotel rates. Core inflation rose 0.3 percent in the biggest monthly rise since late 2009.

"At a minimum it emboldens the hawks, even if Yellen will put a brave face on this and continue to speak about considerable spare capacity in the labour market," said Alan Ruskin, global head of G10 currency strategy at Deutsche Bank.

As a result, futures contracts that aim to predict the path of the Fed funds rate sold off sharply as investors priced in an earlier hike.

The contract for June 2015, for instance, slid to its lowest in over two months at 99.655, implying a rate of 0.345 percent. Currently, the effective funds rate is around 0.10 percent.

Treasuries also suffered, with yields on two-year paper ending at their highest in nine months at 0.49 percent. That in turn widened their premium over German yields to 44 basis points, the most since 2007, and gave the dollar a lift against the euro.

"The (CPI) data is a material positive event for the US dollar, with emerging market and commodity currencies for the moment most vulnerable," added Ruskin.

The euro faded to $1.3546, from a high of $1.3587, as the outlook for U.S. rates contrasted with the European Central Bank's recent decision to ease policy yet further.

The dollar was also up at 102.17 yen and edging away from last week's trough of 101.60.

Equity markets in the U.S. took the inflation news surprisingly well, perhaps in part because it helped assuage fears the economy was drifting toward Japan-like deflation.

The S&P 500 ended near its record high after three days of gains, led by a 1 percent rise in the S&P Financial index. The Dow rose 0.16 percent, while the S&P 500 gained 0.22 percent and the Nasdaq 0.37 percent.

In Asia, Japan's Nikkei firmed 0.45 percent in morning trade while Australia's main index ticked lower. MSCI's broadest index of Asia-Pacific shares outside Japan dipped 0.2 percent.

In commodity markets, the turmoil in Iraq kept oil prices supported. U.S. light crude added 22 cents to $106.58, while Brent oil eased back 17 cents to $113.28 per barrel.

Spot gold settled back at $1,270.90 an ounce after running into profit-taking at Monday peak of $1,284.85.