Dollar fights back as yields surge
Market overview
Global bond markets remain under pressure, with yields across developed economies climbing towards levels not seen for almost two decades. Renewed US-Iran hostilities have pushed Brent crude back above $90 a barrel, reviving inflation concerns and forcing markets to reassess how far central banks may need to tighten policy.
The latest move is increasingly being driven by the front end of yield curves, suggesting investors are focused less on longer-term fiscal concerns and more on the prospect of higher policy rates. That shift is beginning to reshape the FX backdrop. The dollar is attempting to rebuild momentum, the euro faces pressure despite expectations of an ECB hike, while sterling is increasingly exposed to narrowing rate differentials and renewed UK fiscal concerns.
With the Fed, ECB and Bank of England heading towards potentially very different September decisions, relative interest rates are moving back to the centre of currency markets.
USD: Hawkish Fed narrative starts to regain traction
The dollar is finding firmer ground as markets once again focus on the prospect of tighter Federal Reserve policy. Kevin Warsh’s Jackson Hole comments reinforced the Fed’s determination to contain inflation, while rising energy prices have strengthened the argument for keeping monetary conditions restrictive.
US data offered some softer signals yesterday. August manufacturing activity and new orders missed expectations, while the JOLTS job openings rate fell to 4.4%, with July revised down to 4.3%. However, the labour market remains sufficiently resilient for inflation to remain the Fed’s primary concern.
Unless upcoming data deteriorates significantly or renewed Treasury policy announcements revive concerns over the dollar’s longer-term credibility, the greenback has scope to extend its recovery. Attention today turns to the ADP employment report, while speculation around a potential Fed hike on 16 September is likely to remain an important driver.
GBP: Fiscal pressure threatens sterling’s rate advantage
Sterling remains on the defensive, with GBP/USD testing the 1.35 area following several sessions of selling. GBP/EUR continues to trade within its recent 1.1650 to 1.1700 range.
The Bank of England is currently viewed as the least likely of the major developed-market central banks to raise rates this month, with markets expecting no change on 17 September. If both the Fed and ECB tighten while the BoE remains on hold, sterling’s relatively attractive carry advantage would narrow considerably.
Domestic risks are also returning to focus. UK borrowing costs have risen sharply, with two-year yields reaching 4.629%, ten-year yields 5.25% and 30-year yields 5.89%. Higher debt-servicing costs leave the new government with limited room to deliver additional spending while maintaining fiscal credibility ahead of the October Budget.
Sterling should retain support from its liquidity and relatively high policy rate, but investors may become more willing to sell the pound if its yield advantage continues to erode and concerns over government borrowing intensify.
EUR: September hike priced, but dollar strength weighs
Eurozone inflation accelerated to 3.3% in August from 2.9% in July, matching expectations and reaching its highest level in almost three years. Higher energy costs are becoming an increasingly important part of the inflation picture following the renewed rise in oil prices.
ECB rhetoric remains firmly hawkish. Gediminas Šimkus described a September rate increase as very likely and suggested one move alone may not be enough to return inflation to target. However, pushing rates significantly further would move policy deeper into restrictive territory, making the path beyond September less straightforward unless energy pressures begin feeding more broadly into prices.
The euro showed little reaction to the inflation release because a September hike is already largely discounted. Instead, EUR/USD remains vulnerable to renewed dollar demand and stronger expectations for Fed tightening. Near-term support sits around 1.1570, followed by 1.1520.
Looking ahead
US ADP employment: A stronger reading could reinforce expectations for tighter Fed policy and provide further dollar support.
US-Iran tensions: Further escalation would keep oil, inflation expectations and global bond yields firmly in focus.
Fed pricing: Markets will continue assessing the probability of a 16 September rate increase.
ECB expectations: A September hike is heavily priced, placing greater emphasis on guidance for what follows.
Sterling and UK yields: Rising borrowing costs and expectations ahead of the October Budget remain key downside risks for GBP.