The U.S. dollar’s recent rebound appears to be gathering pace as market expectations for Federal Reserve rate hikes firm, even as political and policy risks in Europe and Japan introduce fresh headwinds. According to the analysis, the dollar’s momentum indicators had previously signaled over-extension, but the hawkish tone from Fed Chair Warsh at Jackson Hole has shifted the calculus, increasing the probability of a September rate hike and another move before year-end.
The repricing of Fed policy comes as a cluster of macro events in September and October threaten to reshape the global narrative. A high-stakes meeting between Presidents Xi and Trump on September 24, German state elections, and the European Central Bank’s policy decision are all poised to influence currency markets. While the Xi-Trump talks are expected to focus on trade—particularly rare earths shipments, alleged support for Russia and Iran, and U.S. arms sales to Taiwan—the geopolitical subtext could weigh on sentiment. Neither side is prioritizing currency policy, but the broader signals on U.S. commitment in the region may indirectly affect market dynamics.
In Europe, political uncertainty is rising. German state elections this month carry the risk of an outright win by the AfD in at least one region, a development that could reshape domestic policy debates. Chancellor Merz has framed China’s industrial competition as a key driver of Germany’s lost market share, though estimates suggest only a third of the decline stems from Chinese competition, with the remainder attributed to domestic factors such as energy costs and underinvestment. In France, President Macron’s lame-duck status has raised speculation that ECB President Christine Lagarde could step into domestic politics, a move reminiscent of Mario Draghi’s transition to Italy’s prime minister during a national crisis. Such a shift would immediately trigger a succession battle at the ECB, with Germany’s claim for the top job complicated by broader institutional dynamics within the EU.
The divergence between the Fed and the ECB remains a central theme for currency markets. While the Fed has hesitated to hike rates despite a resilient economy, the ECB has continued tightening, with markets pricing a final hike in December. This gap, rather than any single headline from Beijing, Berlin, or Paris, is expected to drive exchange rate movements through the fourth quarter. The Bank of Japan, meanwhile, faces a different set of challenges. Q2 data showed consumption contracting by 0.1% and capital expenditure shrinking for the third time in four quarters, despite real wage gains. Core inflation has remained below the 2% target all year, yet the yen’s recent losses—modest at just over 4% this year—prompted substantial intervention by Japanese authorities in April, May, and July, totaling an estimated $150 billion. The U.S. Treasury’s unprecedented involvement, including sales of euros rather than dollars, suggests the intervention was as much about signaling as direct currency stabilization.
The Bannockburn World Currency Index (BWCI), which tracks the currencies of the 12 largest economies, rose 0.3% in August after a 0.65% gain in July, bringing its year-to-date increase to about 1.0%. The dollar, which accounts for roughly a third of the index, remained unchanged, tempering volatility. Among G10 currencies, the Canadian dollar led gains with a 2.0% appreciation, followed by the Swedish krona at 0.8% and the Swiss franc at 0.5%. The yen was the sole G10 currency to weaken, falling 1.7% despite intervention efforts. The Russian ruble underperformed, dropping 7.5% in August after a 1.2% decline in July, marking its second consecutive month as the weakest component in the index.
