The dollar pushed toward multi-month highs against major currencies on Tuesday as elevated oil prices and a sharp rise in U.S. Treasury yields reinforced expectations that the Federal Reserve may need to keep raising interest rates.
But the Australian dollar weakened after a rate hike was accompanied by a message markets interpreted as less aggressive than expected.
The euro fell as much as 0.32% to $1.13325, its lowest level in three months. A break below its late-June levels would take the currency to its weakest point in more than a year, extending a decline driven by Europe’s exposure to the global energy shock and rising political risk.
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The pound was also under pressure, falling 0.25% to $1.3221 and remaining close to the three-month low reached last week. The Swiss franc weakened to 0.8335 per dollar, its lowest level in four months.
The moves point to a broader shift in the currency market. European-specific concerns are weighing on the euro and pound, but the dollar is also benefiting from a changing U.S. interest-rate outlook.
Brent crude futures were around $104.50 a barrel on Tuesday after oil prices steadied, remaining at levels that continue to raise costs for energy-intensive industries. At the same time, U.S. Treasury yields have climbed rapidly across the curve as traders assess the inflationary consequences of higher energy prices and the resilience of the U.S. economy.
The two-year Treasury yield, which tends to be particularly sensitive to expectations for Federal Reserve policy, is around its highest level in two years and approaching the psychologically important 5% threshold.
That combination of higher oil prices and higher U.S. yields is changing the dollar equation.
The latest dollar rally is increasingly being driven by the relationship between energy prices, inflation and monetary policy.
Higher oil prices can feed directly into consumer inflation while also increasing costs throughout the economy. If the U.S. economy remains resilient at the same time, the Federal Reserve may have less room to reduce interest rates and could face pressure to maintain or increase borrowing costs.
That prospect has pushed Treasury yields higher and widened the potential interest-rate advantage enjoyed by dollar-denominated assets.
James Lord, global head of FX at Morgan Stanley, said the bank has changed its outlook and now expects “USD strength through year-end and into 2027,” reversing its previous expectation that the dollar would continue declining during the second half of the year.
Morgan Stanley now forecasts the euro falling to $1.10 by mid-2027, citing wider interest-rate differentials between the United States and other major economies, stronger U.S. growth and higher European risk premiums.
“Elevated energy prices, robust US data, and a hawkish (Federal Reserve) reaction function have generated not just a rate hike but likely further hikes to come,” the bank said.
The forecast is significant because the dollar’s recent weakness had been built around expectations of narrowing U.S. rate differentials and a prolonged decline in the currency. A sustained change in the interest-rate outlook would challenge that positioning.
The European Central Bank is moving in the opposite direction. ECB President Christine Lagarde pushed back on Monday against some of the more aggressive market expectations for further ECB rate increases, reinforcing the divergence between the monetary-policy outlooks on either side of the Atlantic.
For currency markets, that divergence matters because interest-rate differentials influence the relative attractiveness of holding assets denominated in different currencies.
Australian Dollar Shows The Risk of An Overly Hawkish Interpretation
The Australian dollar provided a useful counterexample on Tuesday. The Reserve Bank of Australia raised its cash rate by 25 basis points to 4.60%, its highest level in 15 years, saying inflation remained too high and that it was prepared to raise rates further if necessary.
Yet the Australian dollar fell rather than strengthened.
The currency briefly climbed to $0.7029 immediately after the decision before reversing course and falling 0.44% to $0.6988, its lowest level in almost two months.
Australian bond yields also declined after Governor Michele Bullock said the central bank had considered leaving rates unchanged as well as raising them by 25 basis points.
That detail altered the market’s interpretation of the decision.
“While this might sound unremarkable, markets may have been worried the discussion was between 25bp and 50bp,” RBC Capital Markets analysts said.
The episode shows that currencies can respond less to the direction of a rate decision than to the information contained in policymakers’ guidance.
A rate increase that initially appears supportive for a currency can become negative if investors conclude that the central bank is closer to the end of its tightening cycle than previously assumed. That dynamic could also become important for the dollar if markets have already priced an aggressive Federal Reserve response to higher oil prices.
U.S. Data Becomes The Dollar’s Next Test
The next major test for the dollar will come from U.S. economic data due later this week. The personal consumption expenditures price index, the Federal Reserve’s preferred inflation gauge, is due Wednesday, followed by the nonfarm payrolls report on Friday. The figures will help determine whether recent strength in the U.S. economy is sufficient to reinforce expectations for additional Fed tightening.
Markets are currently pricing in more than a 70% probability of a Federal Reserve rate increase at the end of October.
That expectation leaves the dollar increasingly sensitive to incoming data. Strong employment and inflation figures could reinforce the recent rise in Treasury yields and support the currency, while signs of economic weakness or cooling price pressures could challenge the latest rate-hike bets.
The yen, meanwhile, was relatively stable around 157.3 per dollar after surrendering Monday’s gains.
Japan’s top currency diplomat Atsushi Mimura said markets should heed the “very clear” warning delivered by Tokyo and Washington last week regarding the yen. His comments suggest that authorities remain attentive to the currency’s weakness, particularly as higher U.S. yields continue to widen the gap with Japanese rates.
The broader market is therefore entering a potentially important phase for the dollar. Oil at more than $100 a barrel is simultaneously increasing inflation risks and strengthening the case for higher U.S. interest rates, while European currencies face their own economic and political pressures.