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

The U.S. dollar reached near a two-week high on Tuesday, buoyed by a surge in oil prices, rising Treasury yields, and dwindling expectations of a Federal Reserve rate hike this week. The dollar also benefited from weakening risk appetite following a sharp decline in stock markets, with AI-related shares facing pressure due to calls for more cautious development to prevent potential threats to humanity.

Market participants now consider a Fed hike on Wednesday as a near certainty, with the CME's FedWatch tool pricing a roughly 93% probability of an interest-rate increase, marking the first such hike in over three years. Christopher Wong, an FX analyst at OCBC, noted that the combination of higher oil prices, higher U.S. yields, and weaker risk appetite lifted the U.S. dollar broadly.

While near-term support may persist, further dollar upside will likely require the Fed to maintain an open door to additional tightening. The dollar index, which gauges the greenback against a basket of currencies, stood at 99.55. Meanwhile, the euro and British pound weakened against the dollar at $1.1538 and $1.3494, respectively, while the Japanese yen slipped below a seven-month high at 154.72, ahead of an anticipated Bank of Japan rate hike on Friday.

Driven by rising oil prices, benchmark 10-year Treasury yields breached the psychologically significant 5% level for the first time since October 2023, peaking at 4.9895%. Stronger-than-expected August jobs data and a surge in consumer prices further reinforced the belief that the Fed would raise rates on Wednesday. Economists surveyed by Reuters also expect at least one more rate hike by the end of March, reversing a cautious no-change consensus that prevailed before official data revealed robust inflation.

Analysts at BCA argue that the inflation outlook now hinges primarily on oil prices, but the overall macro picture does not warrant more rate hikes than currently priced in the curve. Instead, limited hawkishness from this point forward suggests curve steepening and restrained USD upside. Additionally, the Bank of Japan's decision to raise rates on Friday appears almost certain.

Market sentiment towards the yen is shifting, with speculators adopting a net long position in the Japanese currency for the first time since February. The New Zealand dollar and Australian dollar both slipped slightly, finishing at $0.5769 and $0.7133, respectively. Offshore yuan remained flat at 6.708 per dollar, hovering near its strongest level in over three years, as investors await industrial output and retail sales data later in the day.