The US dollar edged higher on Tuesday but remained pinned near multi-month lows as traders scaled back expectations for another Federal Reserve rate hike. At the same time, long-term Treasury yields pushed to levels not seen in decades, driven by fresh inflation worries linked to the conflict in the Middle East.
According to CME Group's FedWatch tool, the probability of a September rate increase has fallen to 35%, down from 52% just a week ago. That shift reflects a growing view among investors that the Fed may be done tightening, especially after recent data pointed to a cooling jobs market and easing price pressures.
Why the dollar is holding near lows
The dollar's recent weakness is largely a story of changing rate expectations. When traders expect the Fed to raise rates, the dollar typically strengthens because higher yields attract foreign capital. But with odds of a September hike now below 40%, that support has faded.
The euro, for instance, has been able to hold near $1.157, a level that would have seemed unlikely just a few weeks ago. The dollar index, which measures the greenback against a basket of major currencies, has slipped from its recent highs and is now hovering near the lower end of its trading range.
This dynamic is playing out across global markets. In Asia, currencies have gained as the softer dollar provides some relief, even as higher oil prices threaten to stoke inflation. Similarly, emerging market currencies have firmed against the greenback, though central banks like Indonesia's remain on alert.
Long-term yields climb on Middle East worries
While short-term rate expectations have cooled, long-term Treasury yields have been climbing. Investors are increasingly worried that the Middle East conflict could disrupt oil supplies and push energy prices higher, reigniting inflation just as the Fed tries to bring it under control.
Higher long-term yields reflect a market that is pricing in more persistent inflation and larger budget deficits, not necessarily more aggressive Fed action. This divergence between short-term and long-term yields is a key signal for investors: the market is betting the Fed will hold rates steady, but it is also demanding more compensation for the risk of holding bonds over the long haul.
The move in yields has had ripple effects across asset classes. Gold has slipped as rising yields make the non-yielding metal less attractive, while oil's jump has lifted yields and pressured industrial metals like copper.
What this means for investors
For everyday investors, the combination of a softer dollar and higher long-term yields creates a mixed backdrop. A weaker dollar can be a tailwind for US multinational companies, whose overseas earnings become more valuable when converted back to dollars. It can also support emerging market assets, which tend to benefit when the dollar is not strengthening.
However, rising long-term yields are a headwind for bond prices, meaning investors holding long-duration Treasuries have seen their values decline. For those with fixed-income portfolios, this is a reminder that the bond market is still grappling with inflation risks, even as the Fed signals a pause.
The Middle East conflict adds another layer of uncertainty. If oil prices continue to climb, that could push inflation higher and force the Fed to reconsider its stance, which would likely strengthen the dollar again. Conversely, if tensions ease and oil retreats, the current trend of a softer dollar and lower hike odds could persist.
Looking ahead
Investors will be watching upcoming economic data and Fed commentary for clues about the September meeting. The 35% probability is not negligible, and a strong inflation print or a spike in oil prices could quickly shift expectations.
For now, the dollar's path seems tied to the tug-of-war between cooling domestic inflation and external geopolitical risks. As eurozone bond yields have also hit multi-year highs on similar oil-driven inflation concerns, the global picture remains fragile.
In the near term, expect more volatility in currency and bond markets as traders digest every headline from the Middle East and every data point from the US economy. The key takeaway for investors is to stay diversified and avoid making big bets on a single rate decision, as the outlook remains highly uncertain.
