Dollar demand builds as markets reassess global risks
Market overview
The dollar is heading towards its strongest weekly gain in five weeks as geopolitical tension, renewed trade friction and weaker confidence in previously dominant equity themes drive demand for defensive assets. The DXY is closing in on 102, supported by higher energy prices, rising US yields and a resilient domestic economy.
Oil remains central to the market narrative. Brent crude is testing $100 as conflict between the US and Iran continues, while Houthi attacks threaten key Red Sea shipping routes. Expectations of excess supply have quickly been replaced by concerns over disruption, tighter availability and a broader inflationary shock.
Higher energy costs are already pushing inflation risks back into focus and lifting rates volatility. Recent expectations for easier monetary policy are being reassessed, with US Treasury yields returning towards their highs for the year. This move has been reinforced by an exceptionally strong labour market, with initial jobless claims falling to 187,000, their lowest level since 1969.
Fresh US tariffs on more than 60 countries have added to concerns over global growth and supply chain fragmentation. At the same time, signs of fatigue in the AI-led equity rally are making risk appetite increasingly fragile.
FX volatility, however, remains unusually subdued. Investors continue to favour carry trades and higher-yielding currencies, restricting the dollar’s advance despite a supportive macroeconomic backdrop. That stability may prove difficult to sustain.
USD: Strong fundamentals, limited follow-through
The dollar remains well placed to benefit from safe-haven demand, higher yields and renewed inflation concerns. Its upside has so far been restrained by low volatility and continued appetite for carry, but the balance of risks remains tilted in its favour.
The main threat to a broad dollar rally is a sharp unwinding of yen-funded carry trades. Such a move could strengthen the dollar against most major currencies while allowing the yen to outperform.
With the weekend approaching and the Federal Reserve meeting next week, markets may be under-pricing the risk of a more significant adjustment in rates, equities and FX.
GBP: Global pressures outweigh domestic resilience
Sterling is heading for its weakest week against the dollar in five weeks and its poorest performance against the euro since May. The decline initially appeared to reflect profit-taking following a strong summer rally, particularly against the single currency.
As the week progressed, weaker risk sentiment became a clearer driver. Sterling’s sensitivity to global risk appetite has left it exposed, while higher oil prices have supported commodity-linked currencies such as the Norwegian krone and Canadian dollar.
Interest rate expectations are also becoming less supportive. Markets are pricing close to three Bank of England rate rises by mid-2027, but investors may be overestimating the extent to which policymakers will respond to an energy-led rise in inflation.
Stronger-than-expected retail sales failed to generate a meaningful reaction, underlining the market’s focus on external factors rather than UK data. Fiscal concerns have also resurfaced following a series of spending announcements from Prime Minister Burnham.
GBP/USD is approaching its 100-week moving average near 1.32, while GBP/EUR is testing support around 1.17. These levels are likely to be important in determining the next move.
EUR: ECB holds firm as rate expectations rise
The European Central Bank kept all three policy rates unchanged, leaving the deposit rate at 2.25%. President Lagarde maintained the Bank’s meeting-by-meeting approach and reiterated that future decisions will remain data dependent.
She also acknowledged that inflation risks are now tilted to the upside, marking a shift from the more balanced assessment presented at the ECB’s Sintra conference.
The euro response was limited, although the currency briefly fell to a three-week low against the dollar as oil prices climbed. Markets had already moved towards a more hawkish position before the meeting, with the two-year OIS rate trading near its highest level since mid-2024.
Investors are pricing almost two ECB rate increases by year-end, with the first expected in September. Our base case remains for one further rise. A softer labour market and weaker eurozone activity should help contain second-round inflation pressures, particularly if tensions in the Middle East begin to ease.
Looking ahead
The Federal Reserve meeting will be the main event for rates and the dollar.
Oil prices remain a key risk for inflation expectations and global growth.
Any escalation in the Middle East could trigger a broader repricing across FX markets.
Yen-funded carry trades remain vulnerable to a sudden unwind.
GBP/USD at 1.32 and GBP/EUR near 1.17 are the key sterling levels to monitor.
Further ECB tightening may depend on whether energy pressures persist into the autumn.