Dollar sales restrained by oil risk

FX Market Overview

This week's key US inflation data releases were factors that contributed to renewed dollar sales, but the dollar's depreciation this week was quite subdued – apart from oil-linked currencies, most other currencies only rose moderately. Dollar sales are restrained by the risk of further escalation of the conflict in the Middle East, which could fuel a new surge in oil prices. This week's inflation data did not indicate the need for monetary tightening.

GBP

The pound weakened slightly against the dollar at the end of the week but remains close to the level observed before the start of the Middle East conflict in late February. The US dollar and the pound are the two best-performing G10 currencies since the conflict began. The pound has strengthened notably against most other G10 currencies, including the euro – the EUR/GBP pair broke the 0.8500 level for the first time since June 2025.

The biggest single surprise in recent months has been lower-than-expected inflation in the UK. The headline annual CPI figure fell from 3.0% in February, before the conflict, to 2.8% in May; the June reading next week is expected at 2.7%. Core annual inflation is expected at 2.5%. After the start of the conflict, based on a moderate scenario of higher oil prices, a breach of the 4.0% mark by annual CPI seemed quite likely. Energy inflation proved more transitory than expected, with a softer jump in energy prices and a quicker reversal, and housing services (the OFGEM base effect) and food prices helped mitigate overall inflation.

The 5y5y inflation swap rate fell by 20 basis points in May and June and only recovered by 5 basis points after the renewed escalation of the conflict and the jump in oil prices – it is now slightly below the level at the end of February, before the conflict began.

Given the movement in the Gilt market, real yields have risen significantly. With 10-year Gilt yields around 5.00% and deducting the 5y5y inflation swap rate, the 10-year real yield is around 2%. Real yields have risen by a similar magnitude to nominal yields – approximately 75 basis points.

Examining risk reversals and the implied volatility structure in the GBP options market shows that pricing from the moment Andy Burnham confirmed his parliamentary candidacy until today initially demonstrated elevated demand for downside protection in GBP, but this demand has notably decreased.

Investors were concerned about the possible appointment of Ed Miliband as Chancellor due to his leftist views; the probable appointment of Shabana Mahmood, however, was accompanied by a strengthening of the pound. Due to higher inflation, weaker growth, and the need for increased defense spending since the budget, fiscal space has shrunk by approximately £15 billion.

Global risk appetite remains resilient thanks to less disruptive-than-expected energy price increases and continued growth in AI-related risk appetite. Low volatility in the FX market usually coincides with positive pound performance.

USD

The dollar continued its moderate downward correction over the past week, bringing the dollar index back to around 100.00. The dollar weakened against all other G10 currencies except the yen, which continues to lag.

Comments from Japanese officials, including Prime Minister Takaichi's statement about a potential policy shift to encourage domestic investors, including the GPIF, to further increase investments in domestic assets, have so far provided little support for the yen. This effect was most evident in the JGB market, where yields have fallen since late last week. 10-year and 30-year yields are now trading approximately 20 basis points and 25 basis points below recent highs.

According to media reports, the Japanese government has revised its economic policy plan to explicitly state that decisions regarding specific monetary policy tools remain the sole responsibility of the Bank of Japan. Prime Minister Takaichi will have the authority to appoint two new members to the Monetary Policy Board next year when the terms of Hajime Takata and Naoki Tamura expire on July 23, 2027. Both are generally considered "hawks" by Bank of Japan standards. Prime Minister Takaichi's two recent appointments to the Board – Toichiro Asada and Ayano Sato – are considered relatively "dovish."

NOK and NZD

The two best-performing G10 currencies this week were NOK and NZD. The krone recovered amid renewed military tensions in the Middle East, which pushed Brent crude oil prices above $85 per barrel – oil prices are now more than 20% higher than pre-conflict levels. According to Bloomberg, tanker traffic through the Strait of Hormuz has slowed sharply again, and there is no clear understanding of when the current round of military strikes will end.

The release of significantly softer US inflation data this week eased expectations of further Fed rate hikes in the near term, outweighing the usual impact of higher oil prices on the dollar. The decline in headline inflation was broadly expected, given that average gasoline prices fell by approximately 10% in June. The main surprise was the broader nature of the disinflationary trend – core inflation was unchanged month-on-month, which was the biggest downside surprise in core inflation since April last year.

Fed Chair Kevin Warsh welcomed the improved inflation picture but refrained from declaring final victory, reiterating the Fed's commitment to restoring price stability. While the latest data does not completely rule out a Fed rate hike as early as this month, the threshold for further tightening has increased.

YIELD SPREADS MOVED AGAINST THE DOLLAR

Over the past week, Fed governors Christopher Waller, Lisa Cook, and Philip Jefferson stated that they are prepared to support further policy tightening if inflation does not begin to slow down. Dallas Fed President Lorie Logan said she already supports moderately higher interest rates to bring down inflation. Fed Chair Kevin Warsh noted that high-tech spending has grown by almost 25% over the past four quarters, but he does not consider a one-time price increase to be inflationary, as stronger supply should emerge over time in response to increased demand.

The latest Treasury International Capital (TIC) data showed that foreign investors were significant buyers of US equities in April and May, with net purchases totaling $244 billion, bringing cumulative foreign purchases to $904 billion over the past year.

Key Events Next Week

EUR: The ECB will hold its last policy meeting before the summer break on July 23 (deposit rate currently 2.25%, raised by 25 basis points in June). ECB President Lagarde's press conference is on the same day. Releases include Eurozone manufacturing and services PMIs (July 24).

GBP: Labor market and payroll employment data (July 21), June CPI and Producer Price Index (July 22), retail sales (July 24), manufacturing and services PMIs (July 24). Formal appointment of Andy Burnham as Prime Minister is expected on July 20.

JPY: June trade balance (July 22), June national CPI (July 24).

CAD: June CPI (July 20), May retail sales (July 23).

NZD: Q2 CPI (July 20).

AUD: June employment change (July 23).

USD: Initial jobless claims (July 23), composite PMI, new home sales, and building permits (July 24).