The US dollar is demonstrating remarkable resilience, successfully recovering from the correction triggered by weak July labor market data. The EUR/USD pair has retreated for the third consecutive trading day, pulling back from its three-week highs. Investors have shifted into a wait-and-see mode ahead of the key Consumer Price Index (CPI) release, pricing in escalating geopolitical risks in the Middle East.Fundamental prerequisites for an inflation slowdown do indeed exist. Wage growth is currently lagging behind labor productivity gains, and the inflationary impact of previously imposed tariffs is gradually fading. Furthermore, current oil prices remain below their May levels, which most likely marked the peak for CPI in the current cycle.
However, the escalation of tensions in the Middle East suggests that the current deceleration in inflation may be strictly temporary. The derivatives market has swiftly revised its expectations: the implied probability of a Fed rate hike in September has returned to the 50/50 mark, completely erasing the optimism that emerged following the employment data, when the market had priced in a rate hold at the upcoming FOMC meeting.
A similar dynamic is unfolding in the government bond market. Following a brief dip in US Treasury yields triggered by the weak NFP report, the yield curve has pivoted upward once again. The combination of rising yields and renewed expectations of monetary tightening is generating strong downward momentum for the EUR/USD pair.
Market participants remain skeptical about the efficacy of the US administration’s shift from targeted strikes to a strategy of economic blockade against Iran. Tehran possesses extensive experience in weathering sanctions and is fully capable of withstanding the pressure until the US midterm elections. Strategic control over the Strait of Hormuz and operational freedom for its nuclear program are at stake. The stakes are excessively high, prompting the Islamic Republic to continue testing the limits of Donald Trump’s patience through attacks on tankers and energy infrastructure in Persian Gulf nations.
Formally, a deceleration in US inflation should stimulate risk-on sentiment and support the EUR/USD via a rally in equity indices. However, the paradox lies in the fact that the stock market itself is becoming a source of inflationary pressure. Record corporate earnings indicate persistently high aggregate demand, fueled in part by the “wealth effect.” This is leading to a dangerous divergence between the global MSCI index and assets that are highly sensitive to inflationary risks.
If the equity market continues to generate inflationary pressure, it will necessitate a more aggressive monetary tightening from the Federal Reserve. Once investors fully internalize this causal link, the S&P 500 will inevitably face a correction, which, in turn, will provide the US dollar with robust fundamental support and pave the way for its further appreciation.
