Dollar disconnect keeps FX markets on edge

Market overview

FX markets are starting the week with a clear divergence between currencies, bond yields and broader risk signals. The dollar remains under pressure despite a sharp recovery in US real yields, while the euro has held onto recent gains and sterling remains relatively contained. Investors are increasingly questioning whether higher Treasury yields still represent US economic strength, or whether they are instead compensation for rising fiscal risk, heavy debt issuance and policy uncertainty. With US trade tensions, Iran sanctions and Jackson Hole all in focus, the market remains reluctant to build large directional positions, but the underlying bias continues to favour selling dollar rallies rather than chasing them higher.

USD: Higher yields fail to rescue the dollar

The dollar is trading close to three-month lows even though the US 10-year real yield has climbed roughly 70 basis points from its 18-month trough. Historically, that type of move would have offered much stronger support to the currency. Instead, DXY remains near 99, suggesting investors are demanding a greater premium to hold US assets as fiscal concerns and policy intervention reduce confidence in the message being sent by Treasury yields.

The latest expansion of Treasury buybacks has done little to change that picture. Larger long-dated purchases briefly pushed yields lower, but the move quickly faded. While buybacks may improve liquidity in specific parts of the market, they do not remove the underlying issue of heavy debt supply or create sustained demand for duration.

Markets are also reassessing where US rates may ultimately settle. Resilient growth, sticky inflation and limited scope for near-term Fed easing have pushed estimates of the long-run neutral rate higher. A neutral rate around 3.7% would imply a fair-value range of roughly 4.7% to 4.9% for the 10-year Treasury yield, suggesting current levels are not yet signalling a significant overshoot.

The international buyer base is another growing concern. Higher Japanese yields make domestic assets increasingly attractive to Japanese investors, reducing the incentive to own Treasuries once currency and hedging costs are considered. At the same time, persistent US deficits continue to increase the supply of government debt.

Geopolitics adds another layer of uncertainty. Washington's latest sanctions on Iran, including potential penalties for countries maintaining economic ties, could bring China back into focus and revive trade tensions. A renewed US-China dispute would likely add to downside risks for the dollar, particularly if the deteriorating US-Canada relationship also weighs on regional growth.

For now, DXY remains vulnerable below 100. A break under 98.80 could open the door to further weakness, while any recovery towards 100 is likely to remain fragile unless concerns around US fiscal and policy credibility begin to ease.

GBP: Quiet calendar leaves rates in control

Sterling remains relatively steady, with limited domestic data scheduled over the next couple of weeks. That is likely to leave UK rate expectations as the main driver of GBP performance, particularly against the euro.

EUR/GBP has eased back towards the 0.8550 to 0.8560 region, suggesting some of the recent euro premium has faded as conditions in bond markets stabilise. If volatility remains contained, short-term interest-rate differentials should become increasingly important for the pair.

We continue to see risks tilted towards a higher EUR/GBP. Markets are still pricing around 32 basis points of Bank of England tightening by year-end, which looks aggressive. If those expectations are scaled back, sterling could lose support and EUR/GBP may gradually move towards 0.870 over the coming months.

EUR: Holding firm ahead of Jackson Hole

The euro remains well supported against the dollar, consolidating just below 1.17 after last week's break above 1.16. The move has been driven largely by broader dollar weakness rather than a major improvement in the euro area's own outlook, but EUR/USD continues to benefit from growing debate around the long-term credibility of US fiscal and monetary policy.

We expect positioning to remain relatively cautious ahead of Jackson Hole. Warsh's keynote will attract significant attention as investors look for guidance on the Fed's inflation stance and the direction of the new policy framework. Expectations for meaningful clarity may, however, prove too high.

Warsh has already signalled a preference for less forward guidance, so markets may receive little beyond another commitment to controlling inflation. If the speech fails to deliver a clear policy signal, that could leave investors dissatisfied and provide another reason to remain cautious on the dollar.

Closer to home, the German Ifo survey is the main European data point in focus. Business sentiment has shown signs of improvement over the summer, and another firm reading would reinforce the view that conditions in Europe's largest economy are gradually stabilising.

Looking ahead

• US consumer confidence will be watched after softer readings in June and July.

• US housing data could provide further insight into the resilience of domestic demand.

• Wednesday's PCE inflation report will be an important test for US rate expectations.

• Jackson Hole on Friday is likely to be the week's main event for the dollar and global bond markets.

• German Ifo data will offer the next indication of whether the improvement in euro-area sentiment is continuing.

• DXY remains focused on 98.80 to the downside and 100 on the upside.

• EUR/GBP remains sensitive to any repricing of Bank of England rate expectations.