The US dollar extends its winning streak to five sessions as traders prepare for a pivotal Federal Reserve decision, with rising oil prices adding fresh pressure to the inflation outlook.

The US dollar continued to strengthen on Tuesday, with the Dollar Index moving above 99.5 and recording its fifth consecutive session of gains.

The latest advance comes ahead of what could be a major turning point for US monetary policy, with markets expecting the Federal Reserve to raise interest rates this week.

A 25-basis-point increase would represent the first increase in US borrowing costs since 2023 and would mark a significant shift in the Federal Reserve’s recent policy direction.

Markets prepare for the Fed

The rate decision is likely to dominate financial markets this week.

While a 25bp increase is broadly expected, the more important question for investors is what comes next.

The Federal Reserve will also release updated economic projections, giving markets a fresh indication of where policymakers see inflation, economic growth and interest rates heading.

For the dollar, a more hawkish-than-expected message could provide another leg higher.

Conversely, if policymakers signal that this week’s increase could be largely isolated, the recent dollar rally could lose momentum as traders lock in profits.

Oil creates another inflation problem

One of the biggest complications for the Federal Reserve is the sharp increase in oil prices.

Brent crude has moved above $100 per barrel amid growing geopolitical disruption and concerns about global energy supplies.

Higher energy prices can feed directly into headline inflation while also increasing transportation, production and operating costs across the economy.

That creates a difficult environment for central banks.

Even if underlying inflation begins to moderate, a sustained oil shock could slow the process and force policymakers to maintain tighter monetary policy for longer.

For the dollar, this is potentially supportive.

If markets begin pricing a higher probability of additional Fed tightening, US yields can rise relative to other developed markets, increasing demand for dollar-denominated assets.

The dollar’s advantage

The current move in the Dollar Index reflects a combination of monetary-policy expectations and a more defensive market environment.

Investors are reassessing expectations for US interest rates at the same time as concerns over equities and global growth are encouraging demand for traditional defensive assets.

Technology stocks have also come under pressure as investors question the enormous investment being made in artificial intelligence and whether the expected returns will justify the scale of spending.

That combination is helping reinforce the dollar’s position.

The US currency can benefit when investors seek safety, but it can also gain when US interest rates are expected to remain comparatively attractive.

What about the UK and Japan?

The Federal Reserve is not the only major central bank in focus this week.

The Bank of England is widely expected to leave interest rates unchanged on Thursday, while the Bank of Japan is also approaching an important policy decision on Friday.

The divergence between the major central banks could become increasingly important for foreign exchange markets.

If the Fed moves towards tighter policy while the BoE and BoJ remain comparatively cautious, interest-rate differentials could continue to favour the dollar.

However, the situation is not one-directional.

The Bank of Japan’s policy path remains particularly important because any further move towards higher Japanese rates could support the yen and potentially create volatility across major currency pairs.

Can the dollar rally continue?

Five consecutive sessions of gains demonstrate strong short-term momentum, but the Dollar Index is now approaching an area where traders may begin looking for signs of exhaustion.

The immediate catalyst will be Wednesday’s Federal Reserve decision.

A straightforward 25bp increase may already be largely priced into the market.

The bigger move could therefore come from the Fed’s guidance.

A signal that additional increases may be required because of persistent inflation and higher energy prices could push the Dollar Index higher.

A less aggressive outlook could produce the opposite reaction.

Currency Hedger View

From an FX perspective, the dollar is entering an important period.

The combination of higher oil prices, renewed inflation concerns and expectations of tighter US monetary policy is creating a favourable environment for the US currency.

However, much of the immediate Fed move may already be reflected in prices.

The key question for currency markets is therefore not simply whether the Fed hikes, but whether policymakers indicate that another hike could follow.

If markets begin pricing a sustained tightening cycle, the dollar could retain its recent momentum.

If Wednesday’s message suggests that the Fed is nearing the end of the tightening process, traders could quickly reassess the current dollar positioning.

Today Markets View: The dollar remains firmly supported, but Wednesday’s Fed decision could determine whether the five-session rally develops into a broader trend or becomes a classic pre-event positioning move.

Market analysis for Today Markets, with contribution from Currency Hedger, an Octalas Group division specialising in foreign exchange, currency risk and hedging.