The U.S. dollar - mired near seven-week lows against a basket of currencies - is undergoing a "temporary" setback and will strengthen as higher inflation rates force the Federal Reserve to rethink the timeline for the first rate hike, UBS says.
Both the currency market and the Fed continue to underplay rising inflation, according to Mansoor Mohi-uddin, the Swiss bank's chief currency strategist, despite signals from the Fed's own preferred gauge - the personal consumption expenditures (PCE) price index - which has risen 1.8 percent in the 12 months through to May. That's the largest gain since October 2012 and brings the inflation rate closer to the Fed's 2 percent goal set as a threshold for policymakers to consider a rate hike.
"America's economic recovery is beginning to push inflation higher," Mohi-uddin wrote in a commentary on June 29. "The dollar is likely to rebound from its current summer softness as investors start to anticipate when the Fed will begin raising interest rates in 2015. We continue to maintain a constructive view on the dollar this year.'
In the shorter term, currency traders and strategists polled by CNBC expect a turnaround in the U.S. dollar this week. Forty-one percent of survey respondents (7 out of 17) say the dollar will advance, betting scheduled data releases including Thursday's closely-watched jobs report will show the economic recovery is intact.
The poll results correspond with IG Markets' client sentiment survey, which shows that 80 percent of their more-than-500 clients with open positions expect the dollar to gain against the Japanese yen.
Fed Chair Janet Yellen last month described recent inflation data as "noisy" though admitted consumer prices were "a bit on the high side". She did, however, indicate the Fed might tolerate inflation overshooting the 2 percent goal if the U.S. economy was still far from the Fed's goal of maximum employment, the Wall Street Journal reported on June 18.
"The Fed continues to be reluctant to recognize that inflation is on the rise," Hans Goetti, head of investment Asia at Banque Internationale a Luxembourg said. "The trend in the USD depends entirely on the Fed's willingness to look at the facts - inflation rising, labor market improving."
Near-term dollar momentum, however, will remain sluggish with any move to the upside capped by the declining yield on benchmark U.S. 10-year Treasurys.
"I'm bearish on the U.S. dollar in the short term," said Ed Ponsi of Barchetta Capital Management. "Yields on the U.S. 10-year are sinking lower, making them less attractive to investors. As a result, demand for the dollar should soften in the short term."
—By CNBC's Sri Jegarajah