The U.S. dollar held near a two-month high on Monday as the escalating U.S.-Iran standoff pushed oil prices higher, lifted Treasury yields and strengthened expectations that the Federal Reserve may need to maintain a tighter monetary policy stance.
The dollar index, which tracks the greenback against a basket of major currencies, was little changed at 101.14. It was nevertheless heading for a 1.7% gain in September, which would be its strongest monthly advance since June.
The move marks a shift in the drivers of currency markets. After much of the year was dominated by concerns over U.S. trade policy and the dollar’s broader direction, energy prices and inflation expectations have become more necessary as the conflict threatens crude supplies through the Strait of Hormuz.
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Brent crude futures climbed more than 3% on Monday and were last above $107 a barrel after President Donald Trump rejected a proposed peace deal with Iran that could have helped reopen the strategically important waterway.
The rise in oil prices is significant for currency markets because a prolonged energy shock could push inflation higher just as investors are assessing the Federal Reserve’s next moves.
“The greenback could overshoot in the near term if energy market tensions persist and inflation risks continue to build,” said Sim Moh Siong, FX strategist at OCBC.
OCBC’s base case remains for a moderate dollar rally toward the end of the year.
Oil Creates a New Inflation Problem for Central Banks
The market’s immediate concern is the potential interaction between higher energy prices and an otherwise resilient U.S. economy.
Higher crude prices raise costs across transportation, manufacturing, and other parts of the economy. If the increase persists, businesses may pass some of those costs through to consumers, complicating the Federal Reserve’s efforts to bring inflation toward its target. At the same time, stronger U.S. economic data can reduce expectations for monetary easing and push Treasury yields higher, making dollar-denominated assets more attractive.
That combination has been supporting the greenback.
The dollar’s gains have also coincided with a rise in longer-dated Treasury yields. Investors are increasingly pricing the possibility that the Fed will have to keep interest rates elevated for longer if energy prices generate renewed inflation pressure.
Markets currently see a 65% probability of a 25-basis-point Fed rate increase at the October meeting, according to the CME FedWatch Tool, after the central bank raised rates at its September meeting.
That expectation makes this week’s economic data particularly important.
The personal consumption expenditures price index, the Fed’s preferred inflation gauge, is due Wednesday, followed by the nonfarm payrolls report on Friday. Investors will examine both releases for evidence that the U.S. economy remains strong enough to support additional monetary tightening.
“Data could re-emerge as a primary driver for the dollar this week,” said ING FX strategist Francesco Pesole.
“After a good dose of hawkish Fedspeak and Brent staying supported above $100 per barrel, markets now need fresh evidence of US economic strength to solidify expectations of an October 28 rate hike.”
The combination of oil above $100 and stronger-than-expected U.S. economic data would potentially reinforce the case for higher rates. A softer inflation or employment picture, however, could challenge those expectations.
Euro Remains Under Pressure
The euro was slightly weaker at $1.1376, close to a two-month low against the dollar. It was on course for a roughly 2% decline in September. Sterling was marginally higher at $1.3260 but remained close to the three-month low of $1.3204 reached last week.
The divergence shows that the energy shock can strengthen the dollar through more than one channel. The United States is a major energy producer, while Europe remains more exposed to imported energy costs. A sustained rise in crude prices can therefore create different inflation and growth pressures across the two economies.
Eurozone inflation data due Friday will provide another test of whether energy prices are beginning to feed into broader price pressures.
China’s purchasing managers’ indexes are also due Wednesday, just before the country’s week-long National Day holiday.
Yen Rises After Intervention Warning
The Japanese yen strengthened to 156.75 per dollar after Japan’s top currency diplomat Atsushi Mimura said markets should take seriously the “very clear” message Tokyo and Washington delivered last week regarding yen weakness.
Japan’s Finance Minister Satsuki Katayama and U.S. Treasury Secretary Scott Bessent reaffirmed last week that the two countries intend to strengthen cooperation in addressing excessive yen weakness.
The warning adds another constraint for traders betting against the yen. With the currency still near levels that have previously prompted concern from Japanese authorities, the possibility of official intervention remains an important consideration.
Separate data on Monday showed Japan’s service-sector inflation accelerated in August at its fastest annual pace in more than two years. The increase adds to evidence of persistent domestic price pressure and could strengthen the case for the Bank of Japan to raise interest rates more quickly.
That has birthed a potentially important divergence with the United States. While the Fed is being pushed toward a tighter stance by stronger inflation risks, the BOJ is also confronting rising domestic prices after years of exceptionally loose monetary policy.
The Australian dollar was at $0.7016, while the New Zealand dollar stood at $0.5663. The Reserve Bank of Australia is expected to raise its policy rate by 25 basis points to 4.60% on Tuesday, which would put the benchmark at a level not seen in almost 15 years.
China’s offshore yuan edged higher to 6.7159 per dollar following the three-day Trump-Xi summit. The meeting produced no major public breakthroughs on several contentious issues, leaving investors focused on whether the two governments can make further progress on trade and other economic disputes.
For currency markets, however, the immediate driver is the Middle East. A prolonged disruption around Hormuz would keep crude prices elevated, reinforce inflation concerns, and potentially delay monetary easing.
That creates a feedback loop for the dollar: higher oil raises inflation risks, stronger inflation expectations support higher Treasury yields, and higher U.S. yields can increase demand for the greenback.
Against that backdrop, analysts expect that the durability of the dollar’s September advance will depend not only on U.S. economic data, but also on whether the oil shock persists. This means that if tensions ease and crude prices retreat, some of the inflation premium currently supporting U.S. yields and the dollar could diminish. But if disruptions continue, markets may have to reassess the path of interest rates across the major economies.