Yen strength, ECB risk and US inflation set the tone for FX

Market overview

FX markets are balancing rising geopolitical risk, firmer oil prices and a resurgent yen, while the dollar struggles to gain traction. Attention now shifts to the ECB, where a fully priced 25bp hike could still move the euro if policymakers push back against aggressive tightening expectations. With US CPI also due on Friday, the stage is set for a potentially volatile end to the week.

Brent crude is again testing the $100 per barrel area following renewed tensions in the Middle East, yet traditional safe-haven flows into the dollar remain limited. Instead, the Japanese yen has become the dominant force across G10 FX, with further carry-trade unwinding driving sharp moves in JPY crosses and pulling USD/JPY around 2% lower this week.

Elsewhere, sterling and the euro remain relatively resilient despite higher global borrowing costs and growing fiscal uncertainty. Rate expectations are once again taking precedence over geopolitics, leaving markets increasingly sensitive to central bank guidance, inflation and bond yields. With implied volatility still unusually low, the risk is that markets are underpricing the potential for a sharper repricing.

USD: Dollar struggles to find a catalyst

The dollar remains under pressure despite a backdrop that would normally be supportive. Strong US payrolls, higher energy prices and the risk of another inflation impulse should all strengthen the case for tighter Fed policy, yet markets are pricing only around 15bp of tightening for September.

The yen has been the bigger story. Fresh strength in JPY, helped by tougher rhetoric from Treasury Secretary Bessent and renewed concerns over carry-trade unwinds, has weighed heavily on USD/JPY and spilled over into the broader dollar complex. For now, the currency market appears more focused on yen positioning than on the dollar's usual relationship with oil or geopolitical risk.

Friday's US CPI report is therefore increasingly important. A stronger inflation print could revive expectations for a Fed hike and provide the dollar with some support. However, the Treasury market is another source of risk. Around $119bn of issuance and the launch of the Treasury's long-end buyback programme will keep yields firmly in focus, with any renewed weakness in US bonds potentially limiting dollar gains.

GBP: Sterling steady, but fiscal risks are building

Sterling has started the week relatively calmly. GBP/USD is holding in the mid-1.35s after recovering from four-week lows, while GBP/EUR has rebounded into the upper 1.16s. GBP/JPY is the clear exception, falling more than 1.7% this week as yen strength continues to dominate cross-market price action.

External conditions remain challenging. Global yields are rising, energy prices are climbing again and geopolitical tensions remain elevated, yet sterling volatility remains remarkably subdued. Three-month implied volatility in both GBP/USD and GBP/EUR is close to decade lows, suggesting investors remain comfortable despite a growing list of potential risks.

That confidence could be tested as attention turns towards the Autumn Budget. Rising gilt yields are steadily reducing the government's fiscal headroom, with the 30-year yield approaching 6%. Higher debt-servicing costs complicate the fiscal outlook and leave sterling increasingly exposed to domestic policy risk.

For now, markets continue to give the government the benefit of the doubt. Sterling's resilience reflects that confidence, but the balance of risks is shifting towards politics and fiscal credibility as scrutiny of UK policy intensifies.

EUR: ECB expectations leave little room for error

EUR/USD remains anchored around 1.16, with traders reluctant to establish strong directional positions ahead of the ECB and Friday's US CPI release. Higher oil prices have so far had limited impact on the single currency, a notable contrast with earlier stages of the Middle East conflict.

The market is instead concentrating on relative monetary policy. Improving eurozone growth data and a still-firm ECB stance have supported the euro, while expectations for further tightening remain elevated. A 25bp increase to 2.50% this week is fully priced, with markets also discounting roughly 75bp of additional tightening by June 2027.

That leaves the ECB facing a difficult communication challenge. Core inflation eased to 2.4% in August and growth has surprised positively, but higher bond yields and growing fiscal concerns across Europe may make policymakers reluctant to reinforce an aggressively hawkish message.

The risk is therefore that Thursday's meeting proves less hawkish than current pricing implies. Any sign that policymakers are becoming more concerned about overtightening or bond-market instability could trigger a modest pullback in the euro.

With the market already pricing a terminal rate close to 3%, the hurdle for a further upward repricing in rates is high. A more cautious ECB, particularly if followed by a Fed hike next week, would leave EUR/USD facing a less favourable near-term rate backdrop. A move towards 1.150 remains plausible before any broader recovery towards 1.160 later in the year.

Looking ahead

• Thursday: ECB rate decision, with a 25bp hike widely expected. The key focus will be guidance on the path beyond September.

• Friday: US August CPI, potentially the most important catalyst for the dollar and Fed expectations.

• US Treasuries: $119bn of issuance and the start of long-end buybacks could generate additional volatility in yields and USD.

• JPY: Further carry-trade unwinding remains a key risk across G10 FX, particularly for USD/JPY and GBP/JPY.

• GBP: UK fiscal concerns and rising gilt yields are likely to become increasingly important as the Autumn Budget approaches.