Dollar Falls as Risk of Dovish Fed Offsets Boost From Oil Prices

(Bloomberg) — The prospect of a dovish Federal Reserve meeting is competing with higher oil prices to push and pull dollar traders in diverging directions.

That’s leading the spot and options market to take opposing views on the greenback, a notable development after the currency’s worst start to a year on record.

Spot traders are selling the currency against most peers, pushing down a gauge of the dollar to keep it near a three-year low on Wednesday ahead of the Fed’s policy decision later in the day. They are expecting Chair Jerome Powell to acknowledge a recent string of data showing easing underlying US inflation, a potential precursor to interest-rate cuts this year.

Meanwhile sentiment in options for the next month is turning positive, with so-called risk reversals showing traders have abandoned bearish bets for the first time since April. That’s because the escalating conflict between Israel and Iran has buoyed oil prices, offering indirect support to the greenback given the US’s status as a net exporter.

“Escalating military tensions in the Middle East can further lend USD a safe-haven bid and weigh on risk assets,” wrote Elias Haddad, a strategist at Brown Brothers Harriman & Co. “However, we would look to fade USD strength in part because we expect the Fed to deliver a dovish hold today.”

Fed officials are widely expected to leave rates unchanged for a fourth straight meeting, while updating their economic and policy projections. They have previously warned President Donald Trump’s tariffs could boost inflation and unemployment.

Yet data is signaling easing price pressures, with underlying US inflation rising in May by less than forecast for the fourth month in a row. Money markets now favor two 25-basis point reductions by year-end, and assign a 68% probability that the first one will come in September.

“The USD is unlikely to benefit from another steady FOMC meeting outcome,” UniCredit SpA analyst Tobias Keller wrote in a note. “The recent resilience of the US labour market means the central bank can afford to wait for greater clarity regarding changes to government policy and their effects on the economy before it adjusts rates.”

That sentiment left the Bloomberg Dollar Spot Index down 0.1% as of 11:45 a.m. London time, after it posted a 0.5% gain on Tuesday, its biggest daily rally in a month. The divergence between spot and options highlights a recalibration in positioning on the dollar because of the competing narratives, according to interbank traders.

According to ING Groep NV analysts including Francesco Pesole, Tuesday’s advance was likely exacerbated by some positioning squeeze. Should the potential upside for oil prices increase further, they expect the dollar will have room for more gains, with the Fed playing a secondary role to geopolitics.