Dollar rises to 2-week high, Middle East conflict and rate paths in focus

The U.S. dollar soared to a two-week peak on Wednesday, as concerns over the economic fallout from the Middle East conflict and diverging monetary policies across major economies drew investors to the greenback. Iran and its neighboring Arab nations were embroiled in a major exchange of fire between Tehran and Washington since July.

The dollar typically gains traction when oil prices surge, as the U.S. economy is less vulnerable to energy shocks compared to other prominent economies, prompting demand and benefiting currencies like the dollar while undermining others such as the euro and yen.

While most analysts anticipate the European Central Bank to be nearing the end of its tightening cycle following next week's anticipated rate hike, the Federal Reserve grapples with the possibility of instigating policy tightening in 2027, according to senior economist George Brown from Schroders. This disparity in policy paths is expected to widen the rate differentials in favor of the dollar, leading to a weaker euro.

Schroders is positioning for a softer euro and expects it to fall to $1.10 against the dollar by year-end.

However, a sell-off in U.S. Treasuries driven by inflation worries and the country's fiscal outlook could weigh on the dollar, as mounting debt levels and persistent price pressures cast doubts on the long-term allure of U.S. assets. The dollar index, which tracks the greenback against a basket of currencies including the yen and the euro, climbed 0.20 percent to 99.865, its highest level since August 17. The euro declined 0.16 percent to $1.1575, after peaking at $1.1566, its lowest since August 20.

The yield on the benchmark U.S. 10-year note surged to 4.8182 percent, its highest since November 2023. Markets now price a 68 percent chance of a September Fed hike, up from approximately 40 percent a week earlier, as per CME Group's FedWatch tool. Meanwhile, the Japanese yen rose 0.25 percent against the dollar to 159.89 per dollar, nearing the psychologically significant 160-per-dollar mark, as markets assess the Bank of Japan's policy trajectory.

BoJ Governor Kazuo Ueda suggested that consecutive rate hikes may be on the horizon, while hawkish remarks from BoJ member Hajime Takata have bolstered the currency's appeal.