In the FX markets, Monday’s muted reaction in oil prices to weekend Middle East tensions helped pull the US dollar lower across the board. Having failed to break the 100 resistance last week, the US dollar index took a dive to 99.30 – the lowest level since the beginning of June. Yet, the US dollar is rising again this morning, as oil broke its early Monday silence later in the session. US crude jumped past the $85pb level.

US Dollar outlook weakens

Zooming out, since the US jobs data printed a negative number (on the first Friday of August) and the data was backed by softer-than-expected US inflation and retail sales data the following week, the US dollar has become more sensitive to weakening US data, which tames hawkish Federal Reserve (Fed) expectations for the rest of the year.

That situation flips, of course, when the rise in oil prices accelerates. But the broader post-FOMC trend is that soft US data and softening Fed expectations are giving support to major peers. Many now expect that the Fed will skip a rate hike in September. Activity on Fed funds gives a bit more than one chance out of three for a 25bp hike next month.

Today, the USDJPY is pushing higher toward the critical 160 level on the back of a broadly stronger US dollar. Monday’s data showed that Japanese GDP growth unexpectedly slowed as capex declined in Q2, somehow reversing the yen’s appreciation. But the USDJPY remains at a very uncomfortable level for Japanese officials, and reversing the yen’s depreciation sustainably has become a policy priority for the BoJ.

According to a former finance minister, the BoJ should raise rates at every meeting until it reaches 2% to narrow the rate differential with other major currencies and reverse the yen’s weakness in a sustainable manner. But if the BoJ is ready to do so – to hike rates into softening growth and investment numbers – building exposure to the yen is still a risky trade: it comes with the risk that Sanae Takaichi’s government makes a U-turn and re-pressures the BoJ to keep rates as low as possible to prevent a full-blown economic meltdown. It is a fine balance that makes me think that it’s perhaps better to wait before jumping into a long yen trade right now.

For the euro, however, the outlook is improving. The EURUSD yesterday broke above the top of the YTD bearish trending channel and tested the major 38.2% Fibonacci retracement of the January–June retreat to the upside. Clearing the latter resistance could push the currency into what could become a more sustainable medium-term bullish consolidation zone, with support near the 1.15/1.1510 range, an area that has acted as solid support since the beginning of August.

Again, oil prices will remain critical for the US dollar’s short-term direction, yet there are broader factors supporting the positive euro outlook:

For the former – central bank expectations – the Fed/ECB divergence plays in favour of a stronger euro.

For the latter – the debasement trade – the longer-term outlook for the US dollar and Treasuries remains bearish due to the fast-growing US debt and confusion around Fed policy.

Consequently, in the short run, if the Middle East tension trade eases, I expect to see gains in the EURUSD extend above the 200-DMA (presently near 1.1630).

In the medium run, the pair will remain in the bullish trend building since the beginning of 2025 above 1.1350 (major 38.2% Fib retracement of the 2025-to-date appreciation). But we could see resistance into the 1.18/1.20 area if the US-Europe rate differential widens sufficiently to compensate for inflation and attract capital into USD-denominated assets, with Big Tech bonds vacuuming up strong demand from international investors.

Yet, Big Tech doesn’t only issue bonds in USD. The dollar today accounts for roughly two-thirds of Big Tech bond issuance, while foreign currencies have jumped to more than a third this year. Issuing abroad reduces the amount of supply the US dollar credit market has to absorb and could relieve some upward pressure on US corporate yields, but could also limit the US dollar’s capacity to rebound in the longer run while lifting the euro’s prospects as international funding currency.

Note, however, that a sharp rise in European yields due to geopolitical tensions/an energy crisis would have the opposite effect, destroying the growth outlook for Europe and reversing appetite for the euro despite rising yields, while the USD/UST complex is more immune to an energy crisis (as the US is a net exporter of energy). That’s perhaps the biggest risk to the euro’s positive outlook in the short run.