The escalation in the Middle East is evolving into a war of attrition, while financial markets have demonstrated an outsized reaction to June’s US Consumer Price Index (CPI) data. Fed Chair Kevin Warsh cautions against premature conclusions, noting that a single report does not signify a definitive victory over inflation. Nevertheless, the sharp rally in EUR/USD suggests that investors are currently inclined to ignore these warnings, betting instead on a softer regulatory stance.
The geopolitical situation remains highly tense. The Trump administration’s threats to increase military pressure on Iran in the event of a refusal to negotiate are running into internal political divisions within the US. Advocates for a diplomatic solution find themselves in a difficult position, effectively turning the conflict into an endurance test. Washington is keen to avoid prolonging the crisis ahead of the November midterm elections, fearing that a rally in Brent crude could trigger a new wave of domestic inflation. Tehran, in turn, is risking economic stability under the weight of sanctions, betting that the American side will blink first.
The continuation of the Middle East conflict poses serious risks to July’s inflation statistics, which may prove far less favorable than June’s. Recall that in June, US annual inflation slowed from 4.2% to 3.5%, while core CPI eased from 2.9% to 2.6%. These figures temporarily deprived the “hawks” of their main argument regarding the secondary effects of high energy prices. Consequently, market expectations for a Fed rate hike at the upcoming FOMC meeting plummeted from 40% to 17%, immediately putting downward pressure on the US dollar.
The derivatives market has also significantly adjusted its long-term forecasts: the probability of two Fed rate hikes in 2026 has dropped from 58% to 35%. Meanwhile, futures are pricing in two ECB deposit rate hikes, the first of which is expected as early as September. This emerging divergence in monetary policy is temporarily playing into the hands of EUR/USD, prompting a wave of buying activity.
However, it is premature for euro bulls to celebrate. Rising Brent prices carry direct macroeconomic risks for the Eurozone, an economy that remains highly sensitive to energy costs. Can it withstand a simultaneous tightening of the ECB’s monetary policy, or has the derivatives market already priced in an overly optimistic scenario?
Kevin Warsh’s strategic vector remains unchanged: correcting the Fed’s systemic error of allowing inflation to persistently exceed its target over the past five years. All fundamental prerequisites still point to the necessity of raising the federal funds rate. The June slowdown in CPI is likely to be merely a temporary respite, comparable to fragile and difficult-to-enforce ceasefire agreements in the Middle East. Another wave of rising consumer prices in the near term will, with a high degree of probability, return the initiative and the pricing advantage to the US dollar.
