U.S. dollar slips as easing Middle East tensions shift focus to the Federal Reserve

The U.S. dollar weakened against most major currencies on Monday as investors unwound part of last week's safe-haven positioning following signs of easing tensions between the United States and Iran.

The U.S. Dollar Index, which measures the greenback against a basket of six major currencies, hovered around 101.3 during European trading after slipping roughly 0.3% from Friday's levels. The euro rose about 0.3% to around $1.14, while the Japanese yen and British pound also strengthened against the dollar.

Why is the dollar weakening?

The dollar's decline has less to do with U.S. economic data and more with a sharp shift in market sentiment.

The temporary pause in hostilities between Washington and Tehran triggered a steep decline in oil prices, reducing fears of another inflation shock. As oil retreated, U.S. Treasury yields also moved lower, diminishing one of the dollar's biggest sources of support over the past two weeks.

At the same time, investors rotated back toward riskier assets, reducing demand for the dollar's traditional safe-haven appeal.

All eyes on the Federal Reserve

Despite today's pullback, few investors appear willing to make aggressive bets against the dollar ahead of this week's Federal Reserve meeting.

The central bank is widely expected to leave interest rates unchanged, but markets will closely scrutinize Chair Kevin Warsh's comments for clues about the policy outlook. While expectations for a July rate hike have eased, traders continue to see a meaningful possibility of tighter policy later this year if inflation remains elevated.

This week's calendar also includes several key U.S. economic releases that could reshape expectations for the path of interest rates and, in turn, the direction of the dollar.

Outlook

For now, the dollar appears to be caught between two competing forces.

On one hand, easing geopolitical tensions, lower oil prices and softer Treasury yields are weighing on the currency. On the other, the Federal Reserve continues to maintain a relatively restrictive policy stance, limiting the scope for a deeper decline.

Unless geopolitical tensions flare up again, the dollar's direction over the next few days is likely to be driven primarily by the Federal Reserve's policy decision, Chair Warsh's remarks and incoming U.S. economic data rather than developments in the Middle East.