Geopolitics set the tone as FX markets reassess policy risks
Market overview
Markets remain cautious but have stopped short of adopting a full risk-off stance following the latest US-Iran strikes. Investors appear to be treating the return of negotiations as the next major test after talks were suspended during ceremonial funerals for former Supreme Leader Khamenei.
President Trump’s warning at the NATO summit that the ceasefire may already have broken down had a limited market impact. Investors are increasingly accustomed to his strategy of raising tensions before seeking concessions, while reciprocal attacks have characterised the conflict from the beginning.
Oil surrendered part of its earlier advance and remains below $80 a barrel, while equities recovered. With the data calendar light, geopolitical headlines and the outlook for renewed negotiations are likely to drive sentiment into the weekend.
USD: Dollar upside remains constrained
The dollar has struggled to establish a sustained move above 101 as markets take a more measured view of recent developments. Positioning is now less heavily tilted against the currency, reducing the potential for sharp gains driven by bearish trades being closed.
New York Fed President John Williams also drew attention to possible demand-led inflation pressures from the artificial intelligence investment boom. His comments supported the view that the Federal Reserve is unlikely to react aggressively to temporary conflict-related price increases, particularly while energy costs remain contained.
Monetary policy therefore appears well placed for now, leaving the dollar more dependent on geopolitical escalation and any renewed rise in oil prices.
GBP: Higher rate expectations support sterling
Sterling has performed well this week, particularly against the euro, as higher energy prices have encouraged markets to price a more restrictive Bank of England outlook.
UK two-year yields have risen more quickly than equivalent German yields, reflecting concerns that another energy shock could reinforce already persistent domestic inflation. Given the UK’s recent inflation record, investors appear more willing to price additional tightening into sterling than into other European currencies.
Positioning has also been supportive, with crowded bearish exposure limiting the scope for a substantial decline.
Political and fiscal risks remain important. Labour’s leadership nomination process brings Andy Burnham closer to a potential move into Downing Street, but markets will focus on whether any future government can preserve confidence in the public finances. The OBR’s latest warning on long-term debt has kept fiscal sustainability firmly in view.
Sterling remains well supported against the euro, although its outlook against the dollar is less decisive.
EUR: Risk recovery offers limited relief
The ECB’s June meeting accounts delivered a hawkish message, confirming that policymakers had discussed further rate increases in response to concerns over second-round inflation effects.
Since that meeting, the policy debate has become more balanced. Lower oil prices and June’s weaker inflation reading favour a more dovish stance, while renewed US-Iran hostilities strengthen the case for caution.
The euro has recovered some of Tuesday’s losses but remains below its 21-day moving average near 1.1450, suggesting that the broader bearish trend has yet to reverse. The currency has also become more sensitive to changes in global risk appetite, gaining from the equity rebound despite a decline in short-term yields.
A sustained break above the 21-day moving average would probably require a clear improvement in diplomatic rhetoric.
Looking ahead
US-Iran negotiations remain the main near-term market catalyst.
Oil prices will be closely watched for signs of renewed inflation pressure.
The dollar index may struggle to extend gains unless geopolitical risks intensify.
EUR/USD faces resistance near its 21-day moving average around 1.1450.
Sterling’s support will depend on both Bank of England expectations and UK fiscal credibility.