Dollar mostly flat as softer US data fuel dovish rate bets

The U.S. dollar traded mostly flat against major currencies Tuesday, as recent softer economic data fueled market expectations that the Federal Reserve will maintain a dovish interest rate policy. The euro edged down from a two-month high, while sterling hovered near a three-month peak.

Markets have significantly adjusted their outlook for a Federal Reserve rate hike. Following unexpected job losses in July and mild inflation readings, the probability of a September quarter-point hike has shifted dramatically, with a nearly 70% chance now favoring a hold. This dovish interpretation of recent Fed communications and economic indicators has led to a weakening dollar across most currency pairs.

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Current levels, particularly dollar-denominated pairs, are just reflecting the surprised dovishness we saw in the last Fed meeting or at least the interpretation of dovishness.

Adding to market caution are persistent inflation concerns, exacerbated by the ongoing conflict in the Strait of Hormuz and its potential impact on global energy prices. U.S. 30-year Treasury yields climbed to their highest level since 2007, reflecting broader concerns about rising yields worldwide. Brent crude futures held steady around $90.82 a barrel.

Analysts remain watchful of inflation trends. "Inflation has been above target for most of the past five years, and whilst a high 2% annual pace may prove acceptable to the Fed, it leaves the inflation process with little to no breathing room in a world of constant supply shocks," noted Nohshad Shah, head of EMEA fixed income sales at Citadel Securities. The situation is further complicated by geopolitical tensions, with Iran signaling a shift to a "fully offensive" military posture amid stalled peace negotiations.

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Inflation has been above target for most of the past five years, and whilst a high 2% annual pace may prove acceptable to the Fed, it leaves the inflation process with little to no breathing room in a world of constant supply shocks.