HONG KONG — The U.S. dollar is hovering near a two-week high as a renewed oil shock, rising Treasury yields and stubborn inflation rapidly strengthen expectations that the Federal Reserve will raise interest rates this week.
The dollar index, which tracks the greenback against six major currencies, stood around 99.55 in Asian trading Tuesday, supported by a potent mix of higher energy prices, rising U.S. borrowing costs and weaker investor appetite for risk.
Markets are now pricing in roughly a 93% probability that the Federal Reserve will raise rates on Wednesday, September 16, according to CME’s FedWatch tool.
If the Fed acts as expected, it would mark the central bank’s first interest-rate increase since July 2023.
But the real question for currency traders is no longer simply whether rates rise this week.
It is what comes after that.
Why $107 oil suddenly matters to the dollar
Brent crude was trading around $107 a barrel Tuesday, close to a four-month high, after renewed attacks on Saudi energy infrastructure and continuing uncertainty over shipping and diplomacy in the Gulf.
Saudi Arabia’s strategically important East-West pipeline has been disrupted following attacks, while negotiations involving Iran and Gulf states over maritime security around the Strait of Hormuz were postponed.
Concerns over Middle East supply pushed oil sharply higher Monday before prices surrendered some of their intraday gains.
For consumers, higher oil means more expensive fuel.
For central bankers, however, it creates a much larger problem.
Persistently expensive energy can filter into transportation, manufacturing, aviation, food distribution and other costs throughout an economy. If those increases begin influencing wages and expectations about future prices, an energy shock can make inflation much harder to control.
That is precisely what financial markets are worried about now.
Treasury yield breaks through 5%
The bond market has delivered perhaps the clearest warning.
The benchmark 10-year U.S. Treasury yield briefly climbed above 5% on Monday, reaching its highest level since October 2023.
It later eased back below the threshold, trading around 4.99% early Tuesday, but crossing 5% was psychologically and economically significant.
Treasury yields influence borrowing costs throughout the U.S. economy.
When they rise, mortgages, auto loans, corporate borrowing and government financing can all become more expensive.
They can also change the calculation for investors.
At yields around 5%, government bonds become increasingly competitive with stocks because investors can earn comparatively high returns from an asset carrying much lower credit risk than equities.
That has added another source of pressure to stock markets already dealing with concerns over expensive technology valuations and a recent selloff in AI-linked shares.
Fed expectations have changed dramatically
Perhaps the most striking development is how quickly economists have changed their minds.
A Reuters poll conducted just days earlier found roughly 70% of economists expected the Fed to leave rates unchanged at its September meeting.
Following stronger inflation data, rising oil prices and continued labor-market resilience, that consensus flipped.
In the latest Reuters poll, 86 of 101 economists — about 85% — forecast a quarter-percentage-point increase, which would lift the federal funds rate into the 3.75% to 4.00% range.
More than half of forecasters who provided longer-term predictions also expect at least one additional increase by the end of March 2027.
Financial markets have become even more convinced.
Fed funds futures were pricing the probability of a Wednesday increase at roughly 93% by Tuesday.
That is close to certainty by market standards — but it is not a guarantee.
Inflation data changed the conversation
The reversal did not happen because of oil alone.
U.S. employers added 162,000 jobs in August, significantly stronger than economists had expected, while unemployment held at 4.1%.
The report suggested the American labor market remained resilient enough to withstand tighter monetary policy.
Then came inflation.
The U.S. Consumer Price Index rose 0.4% in August from July, while headline inflation stood at approximately 3.4% year on year.
Core prices, which exclude food and energy, increased 0.3% during the month.
The combination gave policymakers little reassurance that inflationary pressure was disappearing quickly enough — particularly with oil prices climbing again.
That helps explain why the debate has shifted from “Will the Fed raise rates?” toward “How many times could it raise them?”
Why higher rates usually help the dollar
Higher U.S. interest rates can make dollar-denominated assets more attractive.
If investors can earn higher yields by holding Treasury securities or other U.S. assets, demand for dollars may increase as international investors move money into the country.
That yield advantage is one reason the dollar has strengthened against several major currencies.
The euro traded around $1.1538, while sterling stood near $1.3494 Tuesday.
The Japanese yen weakened about 0.2% to roughly 154.72 per dollar, pulling back after recently reaching its strongest level in around seven months.
The dollar has also benefited from a second force: uncertainty.
When markets become nervous about wars, energy supplies or falling stocks, investors often seek highly liquid assets such as the U.S. dollar.
The combination of higher yields and risk aversion has therefore created unusually strong short-term support for the greenback.
But dollar bulls may already have a problem
There is a catch.
Markets have already priced in an extraordinarily high probability of a Fed hike.
That means simply raising rates by 25 basis points on Wednesday may not be enough to push the dollar substantially higher.
OCBC foreign-exchange strategist Christopher Wong said the combination of higher oil prices, U.S. yields and weaker risk appetite had supported the dollar, but noted that with a hike already heavily reflected in prices, additional gains could depend on whether the Fed leaves open the possibility of further tightening.
This is a classic financial-market phenomenon.
Markets frequently move on changes in expectations, rather than on an event everyone already expects.
If the Fed hikes but then sounds cautious about further increases, Treasury yields could fall and the dollar’s rally could lose momentum.
If Fed Chair Kevin Warsh signals that inflation remains unacceptable and additional hikes are likely, yields and the dollar could climb again.
That makes his message following the decision potentially more important than the rate increase itself.
The Fed faces a credibility test
The debate has also taken on an institutional dimension.
Some economists argue that with inflation still running above target, the Fed risks damaging its credibility if it refuses to tighten policy after markets have come to expect action.
Reuters’ latest poll found economists increasingly concerned that leaving rates unchanged could actually push longer-term bond yields higher if investors concluded the central bank was becoming less committed to controlling inflation.
The Financial Times has similarly highlighted the debate over whether the Fed is reacting purely to inflation or also trying to reinforce confidence in its commitment to price stability.
Either way, the Fed faces an uncomfortable choice.
Raise rates and borrowing costs rise further.
Do nothing, and investors could become more worried that inflation will remain entrenched.
Japan could add another twist
The Federal Reserve is not the only major central bank in focus this week.
Markets are also expecting the Bank of Japan to raise interest rates Friday, adding another potential source of volatility for the dollar-yen exchange rate.
The yen had strengthened significantly before Tuesday’s pullback, and speculative investors have recently moved into a net-long position on the Japanese currency for the first time since February.
If the BOJ delivers a hawkish message while the Fed sounds cautious about future tightening, the yen could regain ground against the dollar.
If the opposite occurs, dollar-yen could move higher again.
Why this matters beyond currency traders
The consequences extend far beyond foreign-exchange markets.
A stronger dollar makes imported goods cheaper for Americans but can make U.S. exports more expensive internationally.
For companies and governments outside the United States that borrowed in dollars, a stronger greenback can make debt repayments more costly in local-currency terms.
Higher Treasury yields, meanwhile, can tighten financial conditions worldwide because U.S. government bonds are used as a benchmark for trillions of dollars of global borrowing.
And oil above $100 adds another layer of strain for energy-importing economies.
That is why a conflict thousands of kilometers from Washington can eventually influence mortgage rates, stock valuations, currencies and central-bank decisions around the world.
The market has almost decided what the Fed will do — but not what happens afterward
Tuesday’s market signals appear straightforward:
Oil near $107.
Ten-year Treasury yields near 5%.
The dollar near a two-week high.
A roughly 93% market-implied chance of a Fed rate increase.
Yet those numbers may only describe where markets stand before the main event.
With a quarter-point hike already largely priced in, investors will be listening closely for hints about October, December and 2027.
Will the Fed portray Wednesday’s move as a one-off response to an energy shock?
Or will it signal the beginning of another tightening cycle?
That difference could determine whether the dollar breaks decisively higher — or whether traders decide the rally has already gone far enough.
The market appears almost certain the Fed will raise rates on Wednesday. The real cliffhanger is whether Kevin Warsh tells investors it will be the first hike of several.
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