Dollar slips, geopolitical escalation risks seen limited before midterms

On October 13, the US dollar experienced a decline from its 18-month peak, mirroring a drop in oil prices as investors turned their attention to the Federal Reserve's approach towards interest rates. The prevailing belief among traders is that President Donald Trump aims to prevent any escalation in conflicts in the Middle East and Ukraine, as doing so could harm his prospects before the midterm elections.

Trump had previously assured that the US would not attack Iran prior to the elections and highlighted an energy ceasefire between Russia and Ukraine on Sunday. As a result, oil prices experienced a downturn and were poised for a weekly decline due to traders considering the potential influx of additional diesel supplies from Russia.

The September Consumer Price Index reading is expected to shed more light on potential Federal Reserve tightening. Traders have shifted their expectations, now giving an 80% chance of the Fed maintaining rates this month, compared to 51% a month earlier. Furthermore, there is now a 75 basis points of tightening by late 2027, according to the CME FedWatch tool.

While markets would respond to any hawkish surprise, one CPI release is unlikely to dismantle the prevailing narrative of Fed rate pauses, according to Daragh Maher, a senior forex strategist at HSBC. He emphasized that the Fed prioritizes policy decisions based on the overall evidence rather than a single data point. Additionally, a small positive surprise in inflation data could bolster confidence in the already anticipated December hike without substantially affecting the dollar's value.

Traders abandoned their anticipation of a Federal Reserve rate hike later in the month after two policymakers pushed for more evidence before determining whether further tightening is necessary. The US Dollar Index, which measures the dollar's strength relative to a basket of six currencies, fell by 0.25% to 102.29 after hitting an all-time high of 102.61 on Monday, its highest level since April 2025.

Oil prices often strengthen the dollar at the expense of energy-importing currencies such as the euro and yen. The euro rebounded from a near 17-month low on Tuesday, despite another increase in gas prices, a primary contributor to eurozone inflation. Concerns surrounding France's fiscal outlook persisted. Thierry Wizman, a global forex and rates strategist at Macquarie Group, pointed out that any additional negative news could lead the ECB to decelerate the pace of rate hikes or even halt them completely.

A slowdown in rate hikes by the ECB could further weaken the euro against the dollar. Naturlal gas prices reached €86.30, their highest level since December 2022. The Japanese yen strengthened by 0.28% to 158.16 yen against the dollar after Bank of Japan data revealed wholesale prices rose 6.8% year-over-year in September, just below the median market forecast of 7.6% but still reflecting concerns over potential higher interest rates.

The Chinese yuan trading at its strongest level in four years, remaining steady against the dollar at 6.6943 yuan in offshore trade. The Australian dollar remained at $0.6968, barely altered following the release of minutes from the Reserve Bank of Australia's September board meeting, which voted unanimously to raise rates for the fourth time in a year.

The central bank indicated there are still risks of inflation persisting beyond initial projections, thereby keeping the door open for a fifth rate hike this year if required.