Inflation surprise shakes FX markets as dollar gains momentum

Market overview

Currency markets remain volatile as shifting interest rate expectations, geopolitical tensions and uneven economic growth shape movements across major currencies. The dollar has strengthened following hotter US inflation, weighing on the euro, while sterling remains relatively resilient as expectations of further Bank of England tightening build. Elevated energy costs, fiscal uncertainty and contrasting central bank policies continue to create opportunities and risks for businesses with currency exposure.

However, the initial market reaction to US inflation has already faded, with Treasury yields easing and the dollar surrendering some gains. Attention now turns to US producer inflation, the UK's approaching Budget and ongoing European fiscal concerns. With several key drivers competing for direction, further fluctuations across major currency pairs appear likely.

USD: Inflation keeps the dollar in demand

September's US inflation figures exceeded expectations, with headline CPI rising 0.6% month-on-month and core inflation increasing 0.3%, above the 0.2% forecast. Two-year Treasury yields initially jumped 15 basis points, while the Dollar Index broke above 102.607 and approached 103.

The rally subsequently moderated as investors questioned whether the figures warranted a more aggressive Federal Reserve response. Recent comments from Fed official John Williams favouring one further increase followed by an extended pause have reinforced expectations of a measured approach.

Despite political uncertainty ahead of the midterm elections, resilient US growth, elevated yields and geopolitical risks continue to support the dollar. Today's producer inflation figures could provide another boost, with DXY expected to remain above 102.

GBP: Resilient growth supports sterling's outlook

Sterling remains supported after UK GDP grew 0.1% in August, beating expectations of a 0.1% contraction. The positive surprise follows the IMF's upgraded growth outlook, reflecting stronger economic resilience despite elevated energy costs.

Bank of England expectations are also providing support, with markets now pricing a greater than 90% probability of a rate increase next month. Governor Bailey and Chief Economist Pill have acknowledged inflation risks, although both remain cautious about the scale of further tightening.

GBP/EUR briefly reached 1.1867 yesterday before reversing towards 1.1804, suggesting the recent rally may be losing momentum. Nevertheless, firmer economic data and higher rate expectations maintain a constructive outlook for sterling, with the upcoming UK Budget the next major domestic risk.

EUR: Policy divergence keeps the euro under pressure

The euro continues to struggle as widening interest rate expectations favour the dollar. EUR/USD has fallen towards 1.11, its weakest territory since May 2025, bringing the important 200-day moving average into focus.

While persistent US inflation supports a restrictive Federal Reserve outlook, weaker European growth and cautious ECB commentary have tempered expectations of further tightening. French fiscal concerns are adding pressure, with rising European bond yields increasingly reflecting sovereign risk rather than economic strength.

Elevated energy prices and political uncertainty further complicate the outlook. Although EUR/USD appears technically stretched, a sustained recovery lacks a clear catalyst, leaving the 1.11 level vulnerable to further downside.

Looking ahead

• USD: US producer inflation could reinforce dollar strength, with DXY support expected above 102.

• GBP: Bank of England rate expectations remain supportive, although the upcoming UK Budget presents risks.

• EUR: EUR/USD faces a critical test around 1.11, with further weakness possible.

• GBP/EUR: The reversal from 1.1867 suggests consolidation, with 1.18 the immediate level to monitor.

• Broader markets: Bond yields, energy prices and geopolitical developments remain key drivers of FX volatility.