Dollar near two-week high as oil surge lifts yields, Fed hike bets

The dollar rose to a two-week high on Tuesday as surging oil prices pushed up Treasury yields, according to the source. This development reinforced the belief that the Federal Reserve would raise interest rates during a meeting that week, said Christopher Wong, an FX analyst at OCBC in a note. The CME's FedWatch tool priced the likelihood of a rate hike at approximately 93%, marking the first increase in over three years.

The combination of higher oil prices, increased U.S. yields, and waning risk appetite bolstered the U.S. dollar across the board. However, near-term support for the dollar may persist, but further upside could depend on the Federal Reserve keeping the door open for additional rate hikes, noted Wong. The dollar index stood at 99.55, with the euro slightly weaker at $1.1538, as was the British pound at $1.3494.

Meanwhile, the yen declined from a seven-month high of 154.72, dropping roughly 0.2% ahead of a Bank of Japan rate hike anticipated on Friday. Oil prices surged to $107 a barrel, nearing a four-month peak, following an attack by Iran-aligned Houthis on Saudi Arabia and postponed Gulf-Iran talks. This surge contributed to inflation concerns and drove 10-year Treasury yields past the 5% mark for the first time since October 2023.

Stronger-than-expected job growth in August and a spike in consumer prices reinforced the expectation of a Fed rate hike on Wednesday. Economists polled by Reuters anticipate at least one more rate increase by the end of March, reversing a recent no-change consensus. The outlook for inflation now relies heavily on oil prices, but analysts at BCA believe the broader economic picture does not warrant extra hikes beyond those already priced in the yield curve.

Limited hawkishness could result in a steepening of the yield curve and minimal upside for the U.S. dollar. The Japanese yen saw a shift in market sentiment, with traders turning net long for the first time since February. Meanwhile, the New Zealand and Australian dollars slipped by roughly 0.1% to $0.5769 and $0.7133, respectively.

The offshore yuan remained steady at 6.708 per dollar, nearing its strongest level in over three years, as traders awaited industrial output and retail sales data later in the day.