Dollar Holds Firm, Yen Slides to 40-Year Low as Middle East War Fuels Oil...

The U.S. dollar remained resilient on Thursday, hovering near multi-month highs against major currencies as escalating conflict in the Middle East drove oil prices higher, boosted U.S. Treasury yields and prompted investors to scale back expectations for Federal Reserve interest rate cuts.

The greenback edged slightly lower against the euro ahead of the European Central Bank's policy decision but climbed to its strongest level against the Japanese yen since 1986, underscoring widening policy and economic divergences among the world's largest economies.

Markets remain focused on the fallout from the U.S.-Israeli war on Iran, which has severely disrupted shipping through the Strait of Hormuz while attacks by Yemen's Houthi movement in the Red Sea have heightened fears of a broader energy supply shock. The twin threats to two of the world's most important oil transit routes have sent crude prices sharply higher, amplifying inflation concerns and reshaping expectations for monetary policy across global markets.

The U.S. dollar index, which measures the currency against a basket of six major peers including the euro and yen, slipped marginally by 0.08% to 101.06. However, the modest decline masked continued strength in the dollar, which has benefited from its traditional safe-haven status and the relative resilience of the U.S. economy to higher energy prices.

Unlike Europe and Japan, which rely heavily on imported energy, the United States has become one of the world's largest oil and natural gas producers. That has reduced its vulnerability to external energy shocks and strengthened the dollar whenever geopolitical tensions push oil prices higher.

The latest surge in crude prices has also complicated the outlook for interest rates. Investors increasingly believe the Federal Reserve will have less room to ease monetary policy if higher energy costs feed into broader inflation, helping support U.S. Treasury yields and the dollar.

Attention on Thursday also centered on the European Central Bank, which is widely expected to leave interest rates unchanged while maintaining a tightening bias amid renewed inflation risks stemming from the Middle East conflict.

Markets have already priced in two ECB rate increases by early 2027, leaving investors focused on whether policymakers will signal an even more hawkish stance.

"We cannot fully discount the tail risk of an early 25 bps hike (today)," said Michiel Tukker, senior strategist at ING.

"The question is whether markets would interpret this as a hawkish policy turn or whether the move would be perceived as front-loading September's move."

The euro traded 0.09% higher at $1.1423 ahead of the policy announcement.

Yen Still Under Pressure

The Japanese yen remained under the greatest pressure among major currencies, falling to its weakest level against the dollar since December 1986. The currency was last trading at 163.30 per dollar, extending a prolonged decline that has become a growing concern for Japanese policymakers.

While many analysts have attributed the yen's weakness to the Bank of Japan's cautious pace of monetary tightening, others argue that Japan's deteriorating economic outlook is playing an equally important role.

"The consensus view blames a timid BOJ (for the recent yen fall), but I think the problem is that higher oil prices have dashed hopes of 1.5% GDP growth this year," said Kit Juckes, strategist at Societe Generale, noting that the yen has become the weakest-performing currency in the G10 group.

Japan imports nearly all of its crude oil, making the economy particularly vulnerable to sustained increases in global energy prices. A weaker yen further amplifies those costs by making dollar-denominated imports even more expensive, increasing inflationary pressure while squeezing consumers and businesses.

Ironically, expectations for additional Bank of Japan tightening have continued to grow. Japan's two-year government bond yield climbed to a 31-year high on Thursday as investors increased bets that the central bank could accelerate the pace of future interest rate increases to contain inflation and stabilize the currency.

Nevertheless, the widening interest rate gap between Japan and the United States continues to favor the dollar, encouraging investors to borrow cheaply in yen and invest in higher-yielding dollar assets, a strategy that has weighed heavily on the Japanese currency.

Japanese authorities have stepped up efforts to curb speculative selling of the yen.

Finance Minister Katsunobu Kato reiterated on Thursday that the government stands ready to take decisive action in the foreign exchange market if necessary. Tokyo previously intervened directly in April and May after the yen weakened beyond the psychologically important 160-per-dollar threshold.

However, many analysts believe currency intervention alone may offer only temporary relief unless accompanied by broader policy measures.

Mallika Sachdeva, head of forex thematics at Deutsche Bank Research, said a key variable would be whether Japan's Government Pension Investment Fund (GPIF), the world's largest pension fund, is encouraged to increase domestic investments.

"If the Government Pension Investment Fund (GPIF) is mandated to bring money back into domestic assets, this could be very bullish for the yen," she said.

"However, if the BOJ is coopted to support bonds through renewed JGB purchases, this could be very negative."

Japan's finance ministry has recently indicated it wants the country's vast public pension funds to substantially increase investments in domestic assets, a move that could reduce capital outflows and provide structural support for the yen.

Investors are also closely monitoring Japan's fiscal trajectory, which many strategists believe will become increasingly important in determining the currency's long-term direction.

Treasury Continues to Scale Amid Oil Surge

Meanwhile, U.S. Treasury yields continued to climb as investors adjusted to the prospect of higher inflation and fewer Federal Reserve rate cuts.

The benchmark 10-year Treasury yield rose above 4.67%, while the policy-sensitive two-year yield climbed to 4.317%. The 30-year Treasury bond yield also moved above 5.16%, reflecting investor demands for higher compensation amid rising inflation expectations and growing government borrowing needs.

Bond yields and prices move inversely, and rising yields generally support the dollar by making U.S. assets more attractive to global investors.

Energy markets remained the principal driver of global financial sentiment.

Brent crude futures surged $3.80, or 4%, to $97.87 a barrel, reaching their highest level in more than a month and extending gains for a fifth consecutive session.

The rally reflects mounting fears that disruptions in the Middle East could significantly reduce global oil supplies.

Iran's Revolutionary Guards said an oil tanker caught fire following an explosion while attempting to navigate a mined route near the Strait of Hormuz off Oman's coast. Two additional tankers reportedly turned back.

The Guards also declared that the Strait of Hormuz remains under Iranian control and "completely closed" while U.S. military operations continue in the region, warning that no tanker would be permitted to transit the waterway without Tehran's authorization.

The Strait of Hormuz is the world's most important oil chokepoint, handling roughly one-fifth of global oil consumption. Any prolonged disruption could trigger severe supply shortages and sharp increases in energy prices worldwide.

Adding to market anxiety, Yemen's Iran-backed Houthi movement has intensified attacks in the Bab el-Mandeb Strait, another critical maritime corridor connecting the Red Sea with the Gulf of Aden.

The Houthis said on Thursday they struck two Saudi oil tankers as part of what they described as a naval blockade targeting Saudi Arabia.

According to Goldman Sachs, nearly 9 million barrels of oil per day have passed through the Bab el-Mandeb Strait over the past month, including approximately 4 million barrels daily that would be difficult to reroute if multiple regional chokepoints remain blocked.

"The immediate outlook for crude oil remains supportive as markets price a worrying probability of supply interruptions in a second chokepoint," said Pepperstone research strategist Ahmad Assiri.

The conflict continued to escalate militarily.

The U.S. military said it had completed a 12th consecutive night of strikes against Iranian targets, hours after President Donald Trump warned that the United States would destroy an Iranian bridge or power plant each time Iran attacks vessels transiting the Strait of Hormuz.

Goldman Sachs expects oil prices to retain most of their recent gains through July and August, citing declining global inventories, reduced Middle Eastern production, strong seasonal summer fuel demand and a slowdown in releases from strategic petroleum reserves.