FX markets reset as dollar momentum fades

Market overview

FX markets begin the week with the dollar on the defensive, the yen extending its recovery and sterling losing some of its earlier momentum. The euro has also found support, although higher energy prices and geopolitical uncertainty continue to limit conviction across the major currencies. With speculative positioning stretched and central bank expectations shifting, this week’s US data could determine whether recent moves develop into a broader trend or remain a short-term correction.

USD: Hawkish message loses its impact

The dollar’s post-FOMC gains continue to unwind as investors question whether Chair Warsh’s tougher language will lead to meaningful policy action. DXY remains under pressure following last week’s sharp reversal, with Japanese intervention and doubts over the Federal Reserve’s willingness to tighten further weighing on sentiment.

The yen has strengthened by around 4% against the dollar over the past three sessions. However, the scale of the move suggests that a single intervention may not be enough to trigger a lasting reversal of the long-running yen-short trade.

Washington’s apparent willingness to coordinate with Tokyo may also encourage speculation that US officials are becoming more comfortable with a weaker dollar. With speculative dollar longs close to record levels, the risk of further position unwinding has increased.

The US yield curve has continued to steepen, driven primarily by rising inflation expectations rather than higher real yields. A weaker dollar alongside a steeper curve indicates that markets are becoming less convinced by the Fed’s previously hawkish policy signal.

The outlook is not entirely negative. Higher oil prices, geopolitical tensions and fragile risk appetite continue to provide some safe-haven support. Resilient second-quarter growth also suggests that the US economy remains on a firm footing.

GBP: Domestic support begins to soften

Sterling starts the month on a weaker footing after last week’s gains were driven largely by broad dollar selling rather than a clear improvement in UK fundamentals. GBP/USD briefly approached 1.35 before easing towards 1.34, while GBP/EUR remained below 1.17 after retreating from July’s one-year highs.

The recent decline in GBP/EUR still appears corrective rather than the start of a wider trend reversal. The pair remains above its rising 100-day moving average, although the market may need more time to unwind the overbought conditions created by July’s rally.

With few major UK or eurozone releases scheduled, sterling is likely to remain sensitive to global risk sentiment and relative interest-rate expectations. The pound’s earlier support from carry demand, hawkish Bank of England pricing and lower political risk has weakened. Expectations for further tightening have eased and gilt yields have moved lower, reducing sterling’s yield advantage.

Seasonality adds another note of caution. Over the past 20 years, GBP/EUR has fallen in 60% of Augusts, while GBP/USD has declined in 65%, recording an average loss of roughly 0.7%.

EUR: Gains remain tactical

EUR/USD rose to its highest level since mid-June last week after spending much of July close to 1.14. The move was supported by a narrowing in US-eurozone rate differentials as the Fed failed to deliver the hawkish surprise markets had anticipated.

Stronger eurozone growth and inflation figures also reinforced expectations that the European Central Bank will maintain a relatively firm policy stance, providing additional support for the single currency.

Further gains may prove difficult without a clear reduction in Middle East tensions and a sustained fall in oil prices. Elevated energy costs remain a risk to eurozone growth and the region’s terms of trade, while the prospect of a more hawkish Fed continues to cap upside potential.

For now, EUR/USD strength appears tactical rather than the beginning of a sustained move higher. A weaker US employment report would improve the chances of the pair holding near current levels.

Looking ahead

• US ISM surveys will offer an early indication of economic momentum.

• JOLTS data will provide further evidence on labour demand.

• Non-farm payrolls will be the main test for the recent dollar sell-off.

• Middle East developments and oil prices remain important for the euro and broader risk sentiment.

• Sterling may remain vulnerable as its carry advantage weakens and seasonal headwinds increase.