The U.S. dollar extended its decline on Wednesday after weaker-than-expected inflation data sharply reduced expectations that the Federal Reserve would raise interest rates in July.

However, elevated oil prices driven by escalating U.S.–Iran tensions mean inflation risks have not completely disappeared. Apparently, even when one source of inflation cools, geopolitics is eager to provide another.

U.S. Dollar Falls Following CPI Report

The U.S. Dollar Index, which measures the greenback against a basket of six major currencies, edged lower to around 100.81. It had fallen 0.35% in the previous session, marking its largest decline in nearly two weeks and pulling back from its highest level since July 2.

Against major currencies:

• USD/JPY fell 0.1% to 162.08.

• EUR/USD gained 0.1% to 1.1433.

• GBP/USD rose 0.1% to 1.3401.

• NZD/USD traded near 0.5819, close to its strongest level in one month.

• AUD/USD remained steady at 0.6983.

U.S. Inflation Cools More Than Expected

U.S. headline CPI fell 0.4% month-on-month in June, marking its first monthly decline since April 2020, mainly due to lower energy prices.

On a year-on-year basis, inflation slowed to 3.5%.

The softer-than-expected data reduced pressure on the Fed to raise interest rates in the near term. According to fed funds futures pricing, the probability of a July rate hike was cut in half to around 16%.

Treasury Yields Decline as Rate Expectations Shift

U.S. Treasury yields fell following the CPI report. The two-year Treasury yield declined by approximately 9 basis points from its highest level in 16 months.

Lower bond yields reduce the relative appeal of dollar-denominated assets, placing additional pressure on the U.S. currency.

According to Sim Moh Siong, an FX strategist at OCBC, the sizeable downside surprise in inflation gives the Fed greater scope to keep interest rates unchanged for longer.

The Fed Remains Cautious About Inflation Risks

Despite weaker expectations for a near-term rate hike, Fed Chair Kevin Warsh said the central bank has no tolerance for persistently elevated inflation.

His comments indicate that one favorable CPI report is not enough to completely rule out further monetary tightening.

Markets are now awaiting U.S. producer price data for further evidence about the direction of inflation.

High Oil Prices Continue to Create Inflationary Pressure

Escalating tensions between the United States and Iran in the Gulf pushed oil prices back to their highest levels in one month.

The United States reinstated a naval blockade on Iranian ports and launched further strikes intended to weaken Iran’s ability to attack commercial shipping in the Strait of Hormuz.

If oil prices remain elevated, higher energy costs could renew inflationary pressure, limit the Fed’s ability to ease monetary policy, and prevent the dollar from falling much further.

Conclusion

The U.S. dollar is currently under pressure due to cooling U.S. inflation, lower Treasury yields, and weaker expectations of a Fed rate hike in July.

However, the outlook for the greenback is not entirely negative. Elevated oil prices and the Fed’s cautious stance suggest that inflation risks remain present. The dollar’s next move will largely depend on producer price data, oil-market developments, and further policy signals from the Fed.

Soucre: Reuters