Dollar Holds Near Multi-Month Lows as Traders Cut Rate Hike Bets Amid Inflation Risks

By COMFORT OGBONNA

The U.S. dollar edged higher on Tuesday but remained close to multi-month lows against major currencies as investors reduced expectations for further interest rate increases, while escalating tensions in the Middle East kept financial markets on edge.

The dollar’s modest recovery was supported by renewed demand for safe-haven assets as concerns grew that the conflict could intensify and prolong disruptions to global energy supplies.

The euro slipped from a two-month high of $1.161 reached on Monday and was last little changed around $1.157. Sterling fell 0.1% to about $1.352 after weaker-than-expected British labor market data, although it remained close to a three-month high reached in the previous session.

The dollar has faced pressure in recent weeks as economic data have pointed to a softer U.S. economy. Weak employment figures and relatively moderate inflation readings have encouraged investors to scale back expectations that the Federal Reserve will raise interest rates in the coming months.

Markets now see a substantially lower probability of a rate increase at the Federal Reserve’s September meeting. Traders were pricing in about a 35% chance of a hike, down from 52% a week earlier. Investors were also no longer fully pricing in an increase by the end of the year.

The shift in expectations has reduced support for the dollar because higher U.S. interest rates generally make dollar-denominated assets more attractive to investors seeking higher returns.

However, the currency’s decline has been tempered by growing concerns about inflation. The prolonged conflict in the Middle East has pushed oil prices higher and raised the possibility that energy costs could remain elevated for an extended period.

The Strait of Hormuz, a critical route for global oil shipments, remains effectively closed, increasing fears that prolonged disruptions could restrict energy supplies and raise prices for businesses and consumers worldwide.

Those concerns have produced a divergence between currency and bond markets. While currency traders have focused heavily on the weakening U.S. economic outlook and reduced expectations for interest rate increases, bond investors have become increasingly concerned about the possibility of persistent inflation.

Long-term borrowing costs across several major Western economies rose to their highest levels in decades on Tuesday as investors demanded greater compensation for inflation and rising government borrowing requirements.

The combination of higher energy prices and increasing fiscal pressures has complicated expectations for central banks. Even if economic growth slows, policymakers could face difficulty cutting rates aggressively if inflation remains above their targets.

Inflation has remained above the Federal Reserve’s desired level for much of the past five years, leaving policymakers with limited room to tolerate another prolonged increase in prices caused by supply disruptions.

The latest geopolitical developments have further complicated the outlook. Iran has indicated that it could adopt a fully offensive military posture as efforts to negotiate a permanent end to the conflict have stalled, while Washington has ruled out extending an earlier ceasefire arrangement.

A further escalation could increase pressure on oil markets and add to inflation expectations, potentially forcing central banks to keep interest rates higher for longer than financial markets currently anticipate.

The dollar index, which measures the U.S. currency against a basket of major currencies, rose 0.1% to 99.62 as investors sought some protection from the heightened geopolitical uncertainty.

The Japanese yen weakened slightly to around 159.70 per dollar, giving back part of its recent gains following coordinated efforts by the United States and Japan to support the currency at the end of July.

The yen remains under close scrutiny because of the possibility of further intervention by Japanese authorities. The currency had previously weakened toward a four-decade low of 163.99 per dollar, prompting authorities to take action to slow its decline.

Investors are also looking ahead to the Bank of Japan’s next policy meeting, where officials are expected to consider another interest rate increase. Policymakers are also weighing whether the pace of future tightening should be accelerated if inflation and economic conditions allow.

Meanwhile, global bond markets continued to sell off, pushing yields higher as investors assessed the potential impact of elevated oil prices and increased government borrowing.

Brent crude rose 0.2% to $91.10 a barrel, reaching its strongest level since July 30. Higher energy prices have reinforced concerns that inflation could remain elevated, particularly if the Strait of Hormuz stays closed for an extended period.

U.S. 30-year Treasury yields climbed to their highest level since 2007, while government bond yields in other major economies also moved higher. Bond prices and yields move in opposite directions, meaning the rise in yields reflected increased selling pressure.

The increase in long-term borrowing costs is significant because it suggests that investors are becoming more concerned about the longer-term inflation outlook rather than simply focusing on near-term economic weakness.

The bond market is also closely watching U.S. government debt auctions. Investors have demanded relatively high yields to absorb the large amount of Treasury debt being issued to finance Washington’s borrowing needs.

Persistent demand for higher yields could create additional pressure on governments and central banks. Higher borrowing costs increase the expense of servicing public debt while also raising financing costs for businesses and households.

For the dollar, the competing forces have created an uncertain outlook. A weaker U.S. economy and reduced expectations for Federal Reserve rate increases could continue to weigh on the currency, while geopolitical tensions, rising oil prices and safe-haven demand could provide temporary support.

The direction of the dollar in the coming weeks is therefore likely to depend heavily on developments in the Middle East, oil prices, U.S. economic data and the Federal Reserve’s response to changing inflation expectations.

If energy prices remain elevated and inflation proves more persistent than expected, investors could quickly reassess their expectations for U.S. monetary policy. That could strengthen the dollar and push Treasury yields higher.

For now, however, currency traders remain cautious, with the dollar holding near recent lows while bond markets send a more inflation-focused warning about the risks facing the global economy.