Dollar Dips as Fragile Middle East Truce Sparks Risk-On Sentiment

The mighty U.S. dollar found itself on the back foot on Wednesday, struggling to reclaim ground lost as a fragile truce between Israel and Iran, brokered by U.S. President Donald Trump, ignited a flicker of optimism across global markets. This newfound hope, however tenuous, encouraged investors, long starved of positive news, to shed safe-haven assets and embrace a more "risk-on" approach.

Global share indices soared to record highs overnight as both Israel and Iran signaled a halt to their aerial conflict, at least for the moment. This de-escalation followed President Trump's public rebuke of both nations for violating an earlier ceasefire he had announced. The news prompted a significant sell-off in the dollar, which had seen heavy inflows during the preceding 12 days of heightened conflict, including U.S. attacks on Iranian uranium-enrichment facilities.

While currency movements were more subdued in early Asian trading on Wednesday, the euro remained robust, hovering near its October 2021 peak at $1.1621. Sterling also held firm, easing only slightly to $1.3615, not far from its Tuesday high of $1.3648, which marked its strongest level since January 2022. The risk-sensitive Australian dollar, a beneficiary of renewed optimism, edged up 0.02% to $0.6492 after a strong rally in the previous session.

Despite the apparent fragility of the Israel-Iran truce, market participants seem to be embracing any period of calm. Joseph Capurso, head of international and sustainable economics at Commonwealth Bank of Australia, cautioned that "The market is complacent about some of the downside risks. The thing I get is this issue is not over, which means it could come back to be a driver of commodity prices and currency markets again."

Elsewhere in the currency market, the New Zealand dollar strengthened, rising 0.13% to $0.6015, while the Japanese yen remained steady at 144.96 per dollar. A summary of the Bank of Japan's June policy meeting, released on Wednesday, revealed that some policymakers advocated for maintaining steady interest rates due to uncertainties surrounding the impact of U.S. tariffs on Japan's economy. The Swiss franc, which had surged to a 10-and-a-half-year high on Tuesday, stabilized at 0.8049 per dollar. Against a basket of major currencies, the dollar index eased slightly to 97.91.

Federal Reserve and Rate Cut Speculation

Domestically, Federal Reserve Chair Jerome Powell, in his semi-annual testimony to Congress on Tuesday, maintained a cautious stance, reiterating that the central bank was in no rush to ease interest rates. However, market expectations for a rate cut persist, with the CME FedWatch tool indicating an approximately 18% chance of a July cut.

Analysts at ANZ suggest that slowing economic growth and improving services and shelter inflation could outweigh the effects of tariff increases, paving the way for rate cuts to resume in September. Recent weaker-than-expected U.S. economic data has indeed bolstered these expectations, with futures markets pricing in nearly 60 basis points of easing by December.

Tuesday's data, for instance, showed an unexpected deterioration in U.S. consumer confidence in June, as households grew increasingly concerned about job availability. This signals a potential softening in the labor market. In line with these expectations, the two-year U.S. Treasury yield, a key indicator of near-term rate expectations, fell to a 1.5-month low of 3.7870% on Wednesday. The benchmark 10-year yield remained largely unchanged at 4.3043%. The interplay of global geopolitical events and domestic economic indicators continues to shape the trajectory of the dollar and broader financial markets.