Markets turn cautious as geopolitical risks intensify

Market overview

FX markets have taken on a more defensive tone as renewed tensions between the US and Iran push oil prices higher and revive concerns over inflation, interest rates and global growth. The US Dollar Index edged up, Brent crude moved towards $85 a barrel and bond markets sold off as investors reassessed the outlook for monetary policy. Volatility remains relatively contained, but geopolitical developments are likely to remain the main driver of near-term currency moves.

USD: Geopolitical risks reinforce support

The US Dollar Index was modestly stronger after President Trump reinstated the blockade of Iranian ships passing through the Strait of Hormuz and proposed a 20% charge on cargoes using the route.

Details remain limited, and the proposal would be difficult to implement and likely face considerable opposition. However, it has increased concerns over disruption to global trade, higher energy prices and renewed inflationary pressure.

The geopolitical backdrop may also reduce the market impact of today’s US CPI report. In calmer conditions, weaker inflation would usually prompt investors to scale back expectations for Federal Reserve tightening, putting greater pressure on the currency. Higher oil prices and heightened uncertainty now provide a counterbalance to a softer inflation reading.

Markets continue to price around 42 basis points of tightening by year-end, and a significant reversal appears unlikely even if CPI comes in below expectations. The recent escalation strengthens the case for further gains in DXY, with a move towards the 24 June high near 101.80 possible this week.

Investors will also be watching Kevin Warsh’s first congressional testimony today and tomorrow for further guidance on the US policy outlook.

GBP: Yield advantage limits the downside

Sterling lost ground against the US currency at the start of the week as rising energy prices and weaker equity markets reduced demand for risk-sensitive assets.

GBP/USD is losing its grip on the 1.34 level, an area that sits close to several widely followed daily moving averages. However, the broader trend remains constructive. Sterling is still around 0.8% higher this month and more than 1% stronger against the euro, trading near one-year highs against the single currency.

The pound also remains above its key daily moving averages, suggesting that underlying momentum remains positive despite signs of stretched positioning.

A key source of support continues to be the UK’s yield advantage. In a low-volatility market, sterling’s relatively attractive returns encourage carry trade demand, with investors borrowing in lower-yielding currencies such as the yen, Swiss franc and euro to invest in higher-yielding alternatives.

This support is vulnerable to a sharp rise in volatility. A stronger directional move in global markets, higher rates volatility or a renewed risk-off move could trigger a rapid unwind of positions that have benefited from stable conditions.

EUR: Energy pressures return to focus

The euro is once again facing pressure from higher oil prices, weaker risk sentiment and widening rate differentials.

As a major net energy importer, the eurozone is particularly exposed to sustained increases in crude prices. Higher energy costs weaken the region’s terms of trade, raise inflation concerns and place additional pressure on an already fragile growth outlook.

Interest rate differentials are also becoming increasingly important. EUR/USD is often driven more by changes in the US side of the pair than by eurozone developments, meaning a more hawkish Federal Reserve would create an additional headwind.

A return to full-scale conflict is not yet the central expectation, which may limit the extent of the move lower. Even so, a retest of 1.1325 remains possible this week, particularly if US inflation exceeds forecasts.

Looking ahead

• US CPI will provide the next test for Federal Reserve rate expectations.

• Kevin Warsh’s congressional testimony may offer further guidance on the policy outlook.

• Oil prices and developments in the Strait of Hormuz remain central to market sentiment.

• DXY could move towards 101.80 if geopolitical demand continues to build.

• GBP/USD will look to regain support above 1.34.

• EUR/USD could test 1.1325 if inflation data strengthens the case for tighter US policy.