USD: Middle East conflict de-escalates ahead of FOMC meeting

The US dollar has weakened modestly at the start of this week in response to the de-escalation of geopolitical risks in the Middle East. Bloomberg has reported that the US paused military strikes against Iran for the second consecutive night bringing an end to thirteen straight nights of strikes. The New York times reported that President Trump and his advisors have decided to hold off on plans to escalate the US strikes for now, in part over concerns that the war could drain the already diminished stores of Patriot anti-missile interceptors and other air-defence weapons in the region. However, US Ambassador to the Unites Nations Mike Waltz has denied that report saying the US has everything it needs to conduct its campaign. Axios has also reported that Admiral Brad Cooper who is the top US commander overseeing the Middel East, has recommended stopping strikes because they had reached the limit of their effectiveness, citing sources in the region. He reportedly told the White house and Pentagon officials that the strikes had degraded Iran’s ability to attack ships and that the US had exhausted its list of targets. In response to the pause in US military strikes, Iran’s army on Sunday stated that it has also halted its retaliation. The pause has come as Iranian and Imani officials met over the weekend in a fresh attempt to resolve shipping through the Strait of Hormuz. According to reports, the talks were “constructive” and “some progress was made”. The positive developments over the weekend have helped to ease energy supply concerns at least temporarily resulting the price of Brent crude oil dropping back below USD90/barrel overnight after hitting a high at the end of last week of USD102/barrel. It now remains to be seen how long the pause in military strikes will last and how quickly traffic it will be for traffic through the Strait of Hormuz to resume.

In the near-term, the correction lower in energy prices will dampen rate hike expectations for central banks ahead of the Fed’s, BoE’s and BoJ’s latest policy meeting this week. Short-term US yields jumped to their highest levels last week since early in 2025 encouraging a stronger US dollar. On Friday, the US rate market had moved to price in higher probability of the Fed starting to hike rates as soon as this week in response to heightened upside risks to inflation from higher energy prices. There almost 10bps of hikes priced for this week’s policy meeting on Friday but it has dropped back to around 8bp this morning after the positive developments in the Middle East over the weekend.

We have been assuming that the Fed would leave rates on hold this week but one can’t completely rule out the possibility of a rate hike. Adding to the uncertainty is lack of forward guidance provided by new Fed Chair Kevin Warsh. A rate hike this week would send powerful signal at the start of his term that he is serious about improving the Fed’s inflation fighting credibility. However, we are not convinced that he wants to back up his tough talk on inflation with policy action as soon as this week. If inflation risks do not ease over the summer, a September rate hike would become more likely. One FOMC participants who is likely to vote for a hike this week is Dallas Fed President Lorie Logan who favours modestly higher rates to better balance the outlook and risks for the US economy. If the Fed delivers a hawkish surprise and hikes rates this week it would give the US dollar renewed upward momentum. The US rate market would likely move to price in multiple hikes in the absence of clear forward guidance from Fed Chair Warsh.           

BUILDING LONG USD POSITIONS AHEAD OF FOMC MEETING

Source: Bloomberg, Macrobond & MUFG Research

JPY: Pressure on the BoJ to provide hawkish policy guidance

The drop in energy prices at the start of this week has brought some much-needed relief for Japanese policymakers and helped to slow upward momentum for USD/JPY which has held just below the 164.00-level since late last week. Bloomberg has reported that inflation concerns in Japan are having a negative impact on Prime Minister Takaichi’s popularity. A Yomiuri poll revealed her support fell to 57% which was the lowest since she took office last October and drown from a reading of 69% in June. Another survey in the Nikkei newspaper showed that her popularity fell by 10 points to 58%. In the Yomiuri poll, 71% or respondents said they didn’t approve of the government’s efforts to counter inflation which was up 15 points form the last survey.  Overall, the latest readings are still relatively high but do indicate that recent developments have had a negative impact. The government is currently considering whether to deliver a promised sales tax cut on food to help ease inflation pressures and aims to finalize its policy on the issue by early August.

Market attention in the week ahead will be on how the BoJ responds to inflation pressures in Japan. The BoJ are expected to leave rates on hold after hiking at the last meeting in June, but market participants will be watching closely to see if they provide any hawkish signals over future hikes. Bloomberg reported last week that the BoJ was open to a faster pace of rate hikes than every six months while adding that yen weakness was increasing upside inflation risks. Without hawkish guidance, the yen is vulnerable to further weakness especially if the Fed delivers a hawkish policy surprise this week.  Please see our latest FX Weekly for more details (click here).