Dollar Slips as Oil Shock Reshapes Rate Expectations, Leaving Fed Isolated While Global Tightening Bets Surge

The U.S. dollar has retreated from multi-month highs as surging energy prices, driven by the escalating Middle East conflict, force a rapid reassessment of global monetary policy.

Currency markets now swing around a widening divergence between the United States and other major economies, with the Federal Reserve increasingly viewed as the only major central bank not preparing to tighten policy further this year.

Before the outbreak of the U.S.-Israeli war on Iran in late February, investors had positioned for two rate cuts from the Fed in 2026. That outlook has largely evaporated. Markets now see even a single rate cut as uncertain, pushed toward the end of the year or beyond, as oil prices surge and inflation risks intensify.

By contrast, policymakers across Europe and Asia are shifting in the opposite direction. The euro, yen, sterling, Swiss franc, and Australian dollar have all posted weekly gains against the greenback as expectations build for tighter monetary policy outside the U.S. The euro is up about 1.2% on the week, sterling has climbed 1.4%, and the Australian dollar has gained roughly 1.5%, underlining investor confidence that rate hikes may return sooner than previously expected.

At the center of this shift is the oil market, buoyed by the Middle East war. Benchmark Brent crude has surged nearly 50% since the conflict began, at one point nearing $120 per barrel. The disruption stems largely from the effective closure of the Strait of Hormuz, a critical artery for global energy flows. The shock has revived memories of past supply crises and is feeding directly into inflation expectations worldwide.

European policymakers are already adjusting their stance. The European Central Bank held rates steady but signaled growing concern about energy-driven inflation. According to sources cited by Reuters, officials are preparing to debate rate increases as early as next month, with markets now pricing in a hike by June.

“The Fed is signaling a longer pause if inflation stays sticky; the ECB is opening the door to insurance hikes,” Wei Yao, global chief economist at Societe Generale, summarized the divergence.

In the U.K., the Bank of England has also kept rates unchanged but adopted a more hawkish tone. Its guidance triggered a sharp selloff in short-dated government bonds, as traders priced in roughly 80 basis points of tightening by year-end. Similarly, the Bank of Japan has left open the possibility of a rate increase as soon as April, a shift that helped strengthen the yen after months of weakness.

Australia has already moved decisively. The Reserve Bank of Australia has raised rates twice in recent months, with markets expecting further increases as energy costs ripple through the economy.

The Fed, however, remains cautious. Chair Jerome Powell said this week it is still “too soon to know” the full economic impact of the war. That wait-and-see approach means competing risks. Energy experts have noted that higher oil prices could push inflation higher, but aggressive tightening could also amplify the risk of a slowdown if the energy shock begins to weigh on consumption and investment.

This divergence is beginning to weigh on the dollar. The dollar index is down about 1% for the week, its steepest decline since late January. Yet analysts caution against expecting a sustained downturn. The greenback retains structural support from its safe-haven status and from the United States’ position as a net energy exporter.

Carol Kong, a currency strategist at Commonwealth Bank of Australia, noted that prolonged conflict could ultimately strengthen the dollar again.

“The longer the war drags on, the higher the U.S. dollar will go, because it will benefit from safe-haven demand arising from higher uncertainty and also from the U.S. being an energy exporter,” she said.

The pressure is more acute in emerging markets, particularly energy importers. India’s rupee has fallen past 93 per dollar for the first time, extending losses triggered by the oil shock. The currency has declined more than 2% since the conflict began, reflecting concerns over rising import costs, widening fiscal deficits, and slowing growth.

Foreign investors have responded by pulling more than $8 billion from Indian equities this month, the largest outflow since early 2025. Analysts warn that the rupee could weaken further toward 95 per dollar if oil prices remain elevated.

Vivek Rajpal of JB Drax Honore said, “INR could be more vulnerable if the conflict drags on, which mainly reflects its exposure to higher energy prices.”

The broader implication is that the oil shock is no longer confined to commodity markets. It is now reshaping global capital flows, currency valuations, and monetary policy trajectories. Central banks are now being forced to balance inflation risks against fragile growth, while investors reassess the relative appeal of currencies.