FX markets pause as uncertainty lingers

Market overview

FX markets are starting the week caught between two competing forces. Geopolitical headlines remain capable of driving sharp moves in oil and risk appetite, but currencies themselves are increasingly taking their direction from interest-rate expectations, economic data and relative central bank policy.

The latest US-Iran headlines have revived the familiar pattern of optimism followed by renewed uncertainty. Iran has proposed reopening the Strait of Hormuz as part of a broader diplomatic package, while President Trump rejected the latest terms over the weekend. Mediators are continuing efforts to revive negotiations.

Oil remains particularly sensitive to any shift in the Middle East outlook. Prices pushed sharply higher yesterday before easing as Saudi Arabia resumed exports through its East-West pipeline, helping to alleviate some immediate supply concerns.

For FX, however, the bigger message is that policy divergence is returning to centre stage. The dollar is consolidating after a strong month, the euro remains under pressure from the relative rates picture, while sterling is finding support despite higher UK borrowing costs. With a heavy run of US data ahead and UK fiscal policy firmly in focus, this looks set to remain a market where timing matters.

USD: Data takes control

The dollar was relatively steady yesterday despite much larger moves elsewhere, reinforcing the view that US economic data is now the more important catalyst for the next leg higher or lower.

DXY is holding above the 101 area after gaining close to 2% this month, with the summer highs around 101.64 and 101.80 coming back into view. A sustained move towards those levels is likely to depend on whether incoming data justifies further hawkish repricing ahead of the Federal Reserve's October meeting.

Attention now turns to JOLTS data, followed by ADP employment and PCE inflation tomorrow, before Friday's payrolls report. The more important inflation test comes with September CPI on 14 October, the final CPI release before the Fed decision.

For now, the dollar retains support from the relative policy backdrop, but positioning is becoming more sensitive to each data release. Strong numbers would keep upward pressure on US rate expectations, while a softer run could quickly challenge the recent dollar rally.

GBP: Fiscal credibility keeps sterling supported

Sterling strengthened across the board yesterday even as long-dated gilt yields moved higher, an important contrast with previous episodes of UK-specific market stress.

This time, the rise in borrowing costs is being driven more by global forces, including higher energy prices and elevated sovereign yields internationally. That distinction matters. Higher gilt yields do not necessarily carry the same negative signal for sterling when the underlying pressure is being felt across major markets.

The pound also benefited from Chancellor John Healey's Labour conference speech, where he reiterated the government's commitment to its fiscal rules and signalled that difficult choices lie ahead of the 28 October Budget.

Attention now turns to Prime Minister Andy Burnham's conference speech. He is expected to set out plans covering social care, youth unemployment, energy, water and housing, placing the funding of those commitments firmly under the market spotlight.

For sterling, credibility will be the key issue. Markets appear comfortable with ambitious longer-term policy provided there is confidence that borrowing remains under control. GBP/EUR gained around 0.4% yesterday after holding support near 1.1620, although the scope for a significant extension higher may remain limited in the near term. The 1.1670 to 1.1690 region is likely to provide the next area of resistance.

EUR: Rate differentials remain the headwind

The euro remains on the defensive, with EUR/USD trading close to its weakest levels since late July. Domestic eurozone releases are taking a back seat as investors focus on the widening contrast between the US and European rate outlooks.

Technical conditions are becoming stretched, with EUR/USD momentum indicators moving into oversold territory, but that alone may not be enough to reverse the trend. A move towards 1.13 remains possible before buyers regain firmer control.

The ECB also faces an increasingly uncomfortable balance between inflation risks and weaker growth. Higher energy costs complicate the inflation picture, while elevated longer-term borrowing costs are already tightening financial conditions and placing additional pressure on activity.

That leaves expectations for substantial additional ECB tightening vulnerable if economic momentum deteriorates. Consumer sentiment remains subdued, although business activity and investment have so far proved more resilient.

For EUR/USD, the immediate drivers remain largely external. US rate expectations, energy prices and global risk appetite are likely to dictate direction, leaving the euro exposed unless those pressures begin to ease.

Looking ahead

• US JOLTS: The first major test for dollar momentum this week.

• Wednesday: ADP employment and PCE inflation provide the next read on US growth and price pressures.

• Friday: US payrolls could determine whether the dollar can extend its September advance.

• UK politics: Markets will focus on Andy Burnham's Labour conference speech and how new spending commitments would be funded.

• Middle East: Further US-Iran developments remain a potential source of volatility for oil, risk sentiment and energy-sensitive currencies.

• EUR/USD: Relative US and eurozone rate expectations remain the dominant short-term driver.