Forex Today: Tensions re-escalate in Mideast, USD consolidates Fed-inspired rally

Here is what you need to know on Monday, August 31:

Financial markets adopt a cautious stance on the last day of August as investors assess shifting odds of a Federal Reserve (Fed) interest rate hike in September and re-escalating tensions in the Middle East. The economic calendar will feature preliminary August inflation data from Germany later in the day.

Warsh flags unfinished inflation fight, keeps Dollar bulls

Fed Chair Warsh delivered a notably more hawkish-leaning tone at the Jackson Hole Symposium on Friday, with the FXS Speechtracker score at 7.4 versus a 6.5 historical average, underscoring concern that underlying inflation has not yet convincingly moved toward the 2% PCE objective. The insistence that “we have work to do” on prices, alongside a description of financial conditions as far from restrictive and credit markets showing few signs of policy restraint, signalled a bias toward keeping policy tight or tightening further if inflation progress stalls, a backdrop that tends to support the Dollar.

The FXS Fed Sentiment Index holds steady at 129.70, which keeps the policy tone firmly in hawkish territory. The combination of a high index level and an above-baseline FXS Speechtracker score suggests markets will continue to price a vigilant Fed stance on inflation, with any upside surprises in price data likely to reinforce Dollar strength.

The USD Index gained more than 0.5% on Friday and reached its highest level in two weeks above 99.70 heading into the weekend. In the European morning on Monday, the USD Index stays in a consolidation phase at around 99.50. According to the CME FedWatch Tool, the probability of a 25 basis points (bps) Fed rate hike in September currently stands at around 60%, compared to about 40% before Fed Chair Warsh spoke.

Strategists at Rabobank note that markets “accordingly priced a greater probability of additional rate increases” in the wake of Kevin Warsh’s Jackson Hole remarks. However, they highlight that “longer-dated Treasury yields fell,” a move suggesting investors interpreted the speech as “reducing policy uncertainty and reinforcing the Fed’s commitment to restore price stability.” In Rabobank’s words, the reaction effectively “combined a slightly more hawkish near-term policy outlook with lower longer-term inflation and policy-risk premia.”

Meanwhile, the US and Iran exchanged military strikes for the first time in weeks over the weekend. The US forces attacked two rocket launchers on Iran's Larak Island. In response, Iran has targeted US bases in Jordan and the UAE. Crude Oil prices rise in the early European session on Monday, with the barrel of West Texas Intermediate rising about 1.5% on the day at at around $84.

Pressured by the broad-based USD strength, Gold (XAU/USD) declined sharply on Friday and lost more than 3% on the day. After starting the week on the back foot and touching its lowest level since August 19 below $4,400, XAU/USD erased its losses and was last seen trading flat at around $4,450.

EUR/USD clings to small recovery gains near 1.1600 in the European morning on Monday.

GBP/USD stabilizes and fluctuates at around 1.3550 after closing deep in negative territory on Friday.

USD/JPY reached a fresh August-high above 160.00 on Friday but started the week under bearish pressure. At the time of press, the pair was down about 0.3% on the day at 159.60.