ECB in the hot seat as markets search for direction

Market overview

FX markets remain finely balanced, with higher oil prices, firmer global yields and shifting central bank expectations pulling currencies in different directions. Brent above $100 has revived inflation concerns and pushed bond yields higher, but the traditional relationship between rising US yields and a stronger dollar has weakened. Instead, yen strength, questions over US policy and the prospect of further tightening in Europe are keeping the major currencies relatively well supported against the greenback. With the ECB in focus today, UK growth data and US inflation figures due next, markets are entering a potentially decisive stretch for rate expectations across the US, UK and eurozone.

EUR: ECB must deliver on elevated expectations

The euro has remained notably resilient despite the latest rise in energy prices. Rather than focusing primarily on the negative impact of higher oil on eurozone growth, markets have increasingly returned to interest rate differentials as the dominant driver of EUR/USD.

Attention now turns to the ECB, where a 25bp increase in the deposit rate to 2.50% is widely expected. The move is already fully reflected in market pricing, with investors also anticipating close to two additional increases by the end of 2026. Improving eurozone activity has helped reinforce that relatively hawkish outlook.

The challenge for the ECB is that expectations are already demanding. Energy prices have climbed, but evidence of broader inflationary spillovers remains limited. If President Lagarde stresses caution, incoming data or the need to assess the effect of today's move before tightening again, rate expectations could be pared back.

That would leave the euro more exposed to US yields and Fed pricing, particularly if American inflation surprises to the upside. The growth outlook also deserves attention, as higher energy costs threaten to put renewed pressure on household incomes across the region.

USD: Higher yields fail to lift the dollar

The dollar finished Wednesday broadly flat, with DXY holding near 98.8 despite the US 10-year Treasury yield reaching 4.83%, its highest close since October 2023. The index briefly slipped to 98.59 and was unable to regain the 99 level, highlighting the market's reluctance to translate higher yields and stronger oil prices into sustained dollar demand.

That contrasts with the reaction earlier this year, when rising energy prices supported the dollar through improved US terms of trade. Investors are now placing greater weight on the potential drag to growth from persistently high energy costs, while yen strength and concerns around the US policy outlook continue to dilute the benefit of higher rates.

Fed expectations are nevertheless becoming more hawkish. The two-year Treasury yield closed around 4.42%, with markets pricing roughly a 60% probability of a September rate increase. The muted FX response suggests traders still want confirmation from the data before fully committing to that view.

DXY remains vulnerable below 99. Support sits around 98.50, followed by 98.00, while 99.20 is the first meaningful hurdle. A stronger inflation print could reopen 99.70, whereas softer data would challenge expectations for action at next week's Fed meeting.

GBP: Sterling awaits a domestic catalyst

Sterling remains largely rangebound, with GBP/USD holding around the mid-1.35s and GBP/EUR trading in the upper 1.16s. With limited domestic news so far, the pound has been driven primarily by moves in global rates and developments elsewhere in the major currency bloc.

That could change with tomorrow's UK GDP release. The economy has delivered annualised growth of around 1.7% through the first half of 2026, placing the UK among the stronger G7 performers. However, seasonal effects may have flattered the headline figures, leaving the second half of the year facing a more difficult comparison.

Higher energy costs are also beginning to squeeze household purchasing power again, increasing the risk that recent momentum starts to fade. A disappointing July GDP reading would therefore raise fresh questions over the resilience of the UK economy.

For sterling, the implications are significant. Markets currently price around three Bank of England rate increases by summer 2027. Stronger growth would help validate that path, while evidence of a slowdown could encourage a more dovish reassessment and reduce the pound's yield advantage.

Looking ahead

• Today: ECB rate decision and President Lagarde's guidance will be key for EUR/USD and GBP/EUR.

• Thursday: US PPI will offer the next signal on inflation pressures and Fed pricing.

• Friday: UK GDP will test sterling's domestic growth story.

• Friday: US CPI is likely to be the week's most important release for the dollar and expectations ahead of the 15 to 16 September Fed meeting.

• Key levels: DXY support at 98.50 and 98.00, with resistance around 99.20 and 99.70.