• Markets continue to price in the possibility of another Fed rate hike.
• Kevin Warsh has so far placed greater emphasis on price stability than investors initially expected.
• De-escalation between the US and Iran could reduce energy prices and inflationary pressures.
• The euro area could benefit more from lower energy prices because of its dependence on energy imports.
• A downward reassessment of the Fed rate path represents one of the main medium-term risks for the dollar.
• Fed expectations remain supportive for the dollar

The US dollar has benefited in recent weeks from relatively high Treasury yields and expectations that the Federal Reserve may not yet be finished with its fight against inflation. Markets continue to leave room for another US rate hike. However, this pricing could become increasingly difficult to sustain if tensions in the Middle East ease and inflationary pressures begin to moderate. In such an environment, the dollar’s current advantage over the euro could gradually diminish.

The dollar’s recent strength largely reflects monetary policy expectations. When Kevin Warsh took over as Fed Chair, there were concerns that he might eventually come under pressure from Donald Trump, who has repeatedly called for lower interest rates. So far, this scenario has not materialised.

Warsh has repeatedly emphasised the importance of restoring price stability. With inflation still elevated, investors therefore continue to see a possibility that the Fed could tighten monetary policy further. This has helped US yields remain relatively high and provided support for the dollar.

The July FOMC meeting introduced the first signs of uncertainty into this narrative. Warsh did not use the meeting to prepare markets explicitly for another rate hike. His reluctance to provide clear forward guidance weakened expectations of imminent tightening, although it did not remove them completely.

This approach makes incoming economic data even more important. Inflation, employment and wage growth will increasingly determine how investors assess the next Fed move. Strong data could quickly rebuild expectations of another hike, while softer readings could have the opposite effect and put pressure on the dollar.

Developments in the Middle East are another important part of the monetary policy outlook. Problems surrounding shipping through the Strait of Hormuz continue to support energy prices and create additional short-term inflation risks.

A lasting agreement between the US and Iran could change this backdrop significantly. A reopening of the Strait and a reduction in geopolitical risk would likely put downward pressure on oil prices. That, in turn, would weaken one of the key arguments for keeping US monetary policy exceptionally restrictive.

A de-escalation of the conflict could be particularly important for Europe. The euro area remains heavily dependent on imported energy, while the US is in a much stronger position due to its domestic energy production.

Lower oil and gas prices would reduce Europe’s import costs, improve the outlook for businesses and households and support economic activity. From this perspective, the euro could benefit more than the dollar from a lasting improvement in the geopolitical situation.

However, there is also a monetary policy trade-off. Lower energy prices would reduce inflationary pressure in the euro area and could therefore weaken expectations of further ECB tightening. This could limit some of the positive impact on the single currency.

The biggest question is whether current expectations for US interest rates have become too aggressive. Investors are effectively combining expectations of significantly lower inflation over the coming quarters with the possibility of additional Fed tightening. These two assumptions may eventually become difficult to reconcile.

If US inflation continues to move towards the Fed’s target and energy prices fall, the case for another rate increase should weaken considerably. Warsh’s relatively constructive assessment of the disinflationary impact of productivity improvements, including those related to artificial intelligence, could reinforce this argument.

Over the coming quarters, the key risk for the dollar is therefore a reassessment of the expected Fed policy path. The market could gradually move from pricing additional tightening towards a prolonged pause and eventually renewed rate cuts.

Such a shift would reduce the dollar’s interest-rate advantage and could create room for EUR/USD to move higher. The upside for the euro may nevertheless remain gradual, as declining inflation in Europe could simultaneously encourage investors to price a more accommodative ECB policy.

From a technical perspective, EUR/USD is currently trading at an interesting juncture. Following the strong gains seen in late July, the pair is now undergoing a short-term consolidation between 1.1500 and 1.1560. The exchange rate is also trading just below a descending trendline connecting the highs from late January 2026 with those recorded in April and May.

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