Market overview

FX markets enter the session with a clearer bias than earlier in the month. What began as a stop-start reaction to geopolitical headlines has evolved into a more durable dollar-supportive backdrop.

The market is no longer treating de-escalation as automatically negative for the USD. Escalation still favours the dollar through haven demand and higher energy prices, while progress towards a deal could reinforce US growth resilience and rate advantage. In both cases, the hurdle for sustained dollar weakness has risen.

Risk assets have so far absorbed renewed Middle East headlines reasonably well, including fresh US and Israeli military action. However, higher real yields, firmer rate volatility and tighter financial conditions leave markets vulnerable if bond pressure spills over into equities.

USD: macro support replaces headline dependency

The dollar’s recent strength looks increasingly rooted in fundamentals rather than short-term oil or geopolitical shocks.

US real yields have moved materially higher since the conflict began, while rate volatility has also picked up. That combination strengthens the case for a longer-lasting “higher-for-longer” narrative and keeps the dollar well supported.

For now, the USD benefits from three channels: sticky inflation risks, relative US growth outperformance and its role as a safe-haven currency. Peace talks may temper volatility, but they are unlikely to provide a clean bearish trigger for the dollar.

GBP: steady, but not yet convincing

Sterling remains firm after last week’s G10 outperformance, with GBP/USD holding above 1.34 and GBP/EUR still trading in the upper 1.15s. However, the move appears more like a recovery from recent political weakness than the start of a fresh bullish leg.

Domestic sentiment has improved as fiscal concerns have eased and discussion around closer UK-EU ties has helped stabilise the pound. Gilt market volatility has also cooled, supported by calmer global risk conditions and hopes of progress in the Middle East.

The challenge is that the UK data pulse is softening. Cooler labour market indicators and weaker PMIs suggest momentum is fading, reinforcing expectations that the Bank of England will remain on hold next month.

Sterling’s outlook may now diverge by pair. GBP/EUR looks better underpinned, particularly while UK yields remain attractive versus Europe, but a clear break above 1.16 is needed to unlock further upside. GBP/USD looks more exposed as renewed dollar strength caps momentum.

EUR: caught between geopolitics and fading rate support

EUR/USD remains highly sensitive to Middle East developments. Optimism around a possible interim deal briefly lifted the pair, but renewed strikes have since pulled it back below 1.1650 as traders wait for clarity on the direction of negotiations.

The euro has also lost support from rates. At the end of April, markets were pricing a much stronger ECB tightening bias, with around 85bp expected by year-end. That has since eased to roughly 55bp, reducing a key source of support for the single currency.

Even so, weaker eurozone macro conditions limit the euro’s ability to benefit from rate repricing. If the geopolitical stand-off continues into June, FX markets are likely to keep treating headline risk as the dominant driver, leaving rate differentials in the background.

Looking ahead

• German labour market data and May CPI will help shape expectations ahead of the ECB’s June meeting.
• US PCE inflation remains the main data focus, with direct implications for Fed pricing and GDP assumptions.
• EUR/USD downside risks remain elevated if there is no meaningful progress around Hormuz.
• GBP/EUR needs a sustained break above 1.16 to confirm a stronger upside signal.
• A deterioration in global risk sentiment remains the main threat to sterling, particularly if Middle East tensions escalate.