Why have higher energy prices failed to trigger a stronger USD?
In recent discussions, it has been noted that higher energy prices have not led to a stronger USD, primarily due to disappointing US economic data and a more dovish stance from the Federal Reserve. Per the full note from MUFG EMEA, the dollar index has seen downward pressure largely driven by a sharp decline in inflation, which was evident in June's data, where core inflation was flat, surprising markets and giving the Fed room to maintain rates. With no major inflation catalysts expected in the near term, attention should shift to how these dynamics may influence USD positioning ahead of fall meetings and midterm elections.
What the desk is arguing
The dollar's weakness seems to be fueled by recent softer economic data, particularly in inflation metrics. Per the full note from MUFG EMEA, the core inflation rate remained unchanged in June, significantly impacting the Fed's outlook and giving it additional leeway to potentially maintain interest rates during the upcoming meetings.
This disinflationary trend suggests the Fed is likely to pause on rate hikes for the immediate future, shifting focus to upcoming developments in inflation. This dovish shift contrasts with expectations from energy prices typically supporting USD strength, exemplifying market complexities.
Where it sits in our coverage
Our current consensus target for the USD is 1.075 against the EUR, with a range of 1.04 to 1.12. Notable firms include: - jpmorgan: Target of 1.10 for Mar26. - bofa: Contrarily targets 1.04 for Mar26.
This view aligns with the upper end of our consensus, emphasizing the potential for USD floor support as we navigate a shifting economic landscape.
How other firms see it
Most firms, including jpmorgan, view the weaker USD as a temporary phenomenon influenced by recent economic indicators. Conversely, bofa has taken a bearish stance, suggesting that external factors may still lead to a stronger USD than the current trajectory.
Consider monitoring the EUR/USD trajectory as it may reflect broader sentiments tied to U.S. economic performance and Fed policy evolution.
What the calendar says
No high-impact events appear scheduled in the next month that would directly influence these dynamics, keeping a stable environment for USD volatility into the summer period. The focus remains on how inflation data evolves leading into the Fed's next major decisions in September and October.
01The weaker USD is linked to disappointing inflation data, showing a flat core inflation rate in June.
02Expectations of the Fed maintaining rates could provide longer-term support for the dollar.
03Higher energy prices have not catalyzed expected USD strength under current economic conditions.
04Market focus will shift towards economic data releases as they lead into critical Fed meetings.
Market implications
Watch for USD levels around 100 as a potential support, particularly as traders assess inflation data leading up to the September FOMC meeting.
Risks to this view
A reversal in USD sentiment could occur if inflation shows unexpected resilience or if economic data signals a quicker tightening path for the Fed, prompting a stronger dollar outlook.
Welcome to the MUFG Global Markets FX Week Ahead podcast with Lee Hardman, Senior Currency Analyst. It's Friday, 17th July 2026, and joining Lee to pose some questions on the financial market themes for the week ahead is Abdulahad Lockhart, Currency Analyst. This material is only intended for professional investors in jurisdictions in which its use is permitted under applicable laws, rules and regulations.
It has been produced for information purposes only and should not be construed as investment research or advice. MUFG EMEA disclaimers and disclosures can be located on our website. Hi Lee.
Hi Abdulahad. So the dollar has continued to correct lower over the past week. What has been the main drivers?
Yeah, like you said, over the last couple of weeks, the dollar has definitely lost some upward momentum. And if you say we've seen the dollar index kind of moving back towards support closer to the 100 level over the past week. To us, the kind of main driver really has been the disappointing in the US data where we saw clear evidence of much softer US inflation in the month of June.
It was obviously widely expected that headline inflation would slow because gasoline prices had fallen on average by about 10 percent in the month of June, which obviously helped to bring down headline inflation. But I think the biggest surprise really was the I guess the broader evidence of disinflation pressure. So if we look at core inflation, for example, that was flat month on month.
I think that was the biggest downside surprise since May of last year. So that definitely is good news for the Fed and for financial markets. It should give them more leeway to leave rates on hold this month.
Then give them time over the summer to see how inflation risks develop before we get to the kind of next FOMC meetings in September and October, closer to the midterm elections in November. It's our view still that we think that the Fed can look through this period of higher inflation. Yes, at the moment, they're clearly kind of talking tough on inflation.
We've seen three Fed governors over the past week, Christopher Waller, Lisa Cook, and also Jefferson as well, have all indicated that they are uncomfortable about the current level of inflation and are prepared to hike rates if inflation doesn't slow. But we still think that over the summer period, we should see more evidence emerging that inflation is slowing down, which then would give them the justification to leave rates on hold. So that's still kind of a key assumption behind our forecast for the dollar to weaken further as we head into year end.
There are obviously risks to those forecasts, the most obvious being the renewed military strikes in the Middle East, which have lifted the price of oil back above $85 per barrel. Obviously, the longer that conflict goes on, the greater the risk that that could prove more inflationary and put Fed rate hikes onto the table, which would clearly be an upside risk to our forecasts for a weaker dollar. We're also monitoring closely as well, recent developments in the equity market, where we've seen some weakness in AI-related equities.
Obviously, after a strong run higher for AI-related equity performance in the months of April and May, over the past month or so, we have seen AI-related equity indices coming under some selling pressure. Obviously, if that correction lower was to deepen more significantly, that as well could pose some risks for carry trades in the FX market. If we were to see financial market stability being threatened, that would make conditions for carry trades much less attractive.
And additionally, in terms of dollar positioning, that also could be a negative factor for the dollar. If we look at the recent tick data from the U.S. Treasury, we can see there that there was significant buying of U.S. equities by foreign investors up to the month of May, which highlights there that the market is more heavily positioned long U.S. equities.
So, if we were to see a significant correction lower for AI stocks, that could also feed and spill over into some weakness in the dollar as well. Actually. So, of the majors, sterling has been outperforming recently.
Do you expect sterling to strengthen further? Yeah, like you say, I think it's been somewhat surprising that the pound has performed so well, really, since the Middle East conflict started back in late February. And definitely over the past month, we've seen the pound clearly outperforming against both the euro and the dollar, despite the kind of political risks that have been in focus in the U.K.
I think, obviously, one of the reasons why the pound has strengthened is that I think the market was obviously overly kind of pessimistic, at least initially, when speculation starts to build over the prospect of Andy Burnham becoming the next prime minister of the U.K. So, the market was fearful that that could lead to a bigger shift to the left in terms of economic and fiscal policies here in the U.K., adding to fiscal risks and economic policy risk in the U.K. But what we've seen really over the last kind of two to three weeks has clearly been that Andy Burnham's team have come out to reassure financial market participants that they will stick to fiscal discipline as a key, I guess, key plank of their economic policy agenda, committing to maintain the current government's fiscal rules.
And as well, on top of that, in recent days, there's been media reports suggesting that Andy Burnham is likely to choose Home Secretary Mahmood to be the next chancellor, and in the process kind of overlooking former labor leader Ed Miliband. I think the market is initially relieved that Miliband looks like he's unlikely to be the chancellor now, given that he's more from the left wing of the Labour Party and also is associated with more kind of growth negative policies, such as his kind of more strict adherence to environmental policies. So, from that perspective, if we do see confirmation early next week that Mahmood is likely to be the next chancellor, I think that is also helping to ease those kind of fiscal risks in the UK.
I'd say as well, the other kind of factor which has definitely helped the pound to perform well at the start of this year is also the stronger growth that we've seen for the UK economy. If we look at the latest forecasts from the IMF, the UK is one of only few economies which have seen upward revisions to their growth forecasts for this year. And as we saw earlier this week as well, we did see another upside surprise in terms of the monthly GDP data, which points towards a modest upward revision to growth in Q2.
So, I think the kind of cyclical momentum for the UK economy has also been providing a tailwind for pound performance. We would say, though, that I think at these kind of stronger levels now that we do think a lot of that kind of good news is already priced into the pound, and it could leave the pound more vulnerable to the downside going forward if we do see any signs of disappointment, whether that's in terms of Andy Burnham's policy platform when he is prime minister, or alternatively, we start to see some signs of softening and a growth momentum in the UK. I know as well, Abdullah that you've also been taking a look in more detail at the latest FX options flow data and also price action.
Be interesting to see if there are any signals there that you think could be important in terms of pound performance going forward. Yeah, thanks Lee. So, this week we took a look at the FX options markets and how they're interpreting Andy Burnham's premiership, and whether investors are pricing in a meaningful UK political risk event.
And in short, the answer is not really at this stage. So, our framework aggregated signals across pound crosses and converted them into four market pricing indicators. So, direction, uncertainty, tail risk and persistence.
So, direction told us whether investors were paying more for pound upside or pound downside protection. Uncertainty captured demand for larger potential moves in pound, regardless of direction. And tail risk looks at whether markets are hedging against extreme pound outcomes.
And persistence shows whether any risk premiums is becoming embedded across medium term tenors. So, when we look at our signals today, investors are showing more interest in pound upside optionality than in downside protection. And implied volatility remains subdued, pound specific volatility premia are contained across most crosses, and tail risk pricing is exceptionally low.
So, in other words, the options market is not behaving as though an impending Burnham premiership represents a major fiscal or political shock for sterling. So, we characterize this as a pound relief trade regime. And the pound options market appears to be seeing Burnham's premiership as broadly benign for pound, with pricing tilted more towards relief than stress.
So, however, the low levels of volatility may itself warrant caution. So, cable one month implied volatility is well below the May shock level. And we determine that based on when Andy Burnham first announced his standing in the Makefield election.
And that even though the policy outlook currently remains uncertain. So, reports of a potentially more ambitious autumn budget, including ideas such as land tax and greater public control of utilities and expanded devolution mean fiscal risks could still emerge later in the year. But for now, the market's message is clear.
Pound options are not pricing in Burnham as a material risk event. They're pricing in relief, not fair. Great.
That's good to hear, Abdullahad. And yeah, that brings an end to today's podcast. Thanks for joining, Abdullahad.
And yeah, hope everyone has a good week ahead. Thank you for listening to this MUFG Global Markets podcast. Rate, review and subscribe.
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