The US dollar is currently locked in a struggle between oil prices and the Federal Reserve, according to a report from a senior currency strategist. This conflict originates from the long-standing relationship between the dollar and crude oil beginning to break down.

Historically, crude oil (such as New York crude and Brent crude) and the US dollar have moved in opposite directions. Since oil is priced in dollars, a stronger dollar typically suppresses commodity prices, as foreign buyers need more of their local currency to purchase crude. This relationship began to shift in 2022, following Russia's invasion of Ukraine and the US solidifying its position as a major energy exporter. The change has intensified due to the conflict in Iran disrupting shipping through the Strait of Hormuz. The traditional negative correlation between crude oil and the dollar started weakening after the 2014 oil price crash, and the Russia-Ukraine conflict in February 2022 accelerated this trend.

In the past, rising oil prices would almost certainly have a negative impact on the US economy. However, the current Iran conflict, which has triggered the largest energy supply crisis in history, has created an opportunity for major US oil companies to increase production and enjoy high prices, boosting US energy exports. The booming US energy sector has significantly differentiated its economic situation from other major economies. For example, the Eurozone, which remains heavily dependent on energy imports, is more susceptible to the combined pressure of higher inflation and weaker economic growth.

Since the conflict began, this divergence in economic fundamentals has further solidified the dollar's traditional safe-haven status. The US Dollar Index was quoted at 99.71, down 0.26 points (-0.26%), during normal market trading. At the start of the conflict, the market widely anticipated a decline in the dollar. This short position reflected the mainstream expectation at the time that the Federal Reserve might cut interest rates this year, combined with the lingering effects of last year's market discussions about de-dollarization and the long-term structural outlook for the dollar.

Following the outbreak of the conflict, investors rushed to cover their short dollar positions, amplifying the dollar's initial rally. As long as shipping through the Strait of Hormuz remains restricted, the dollar is likely to maintain its safe-haven premium, supported by the US's status as an energy exporter.

However, another opposing force continues to act on the dollar: the Federal Reserve. The July non-farm payrolls data fell significantly short of expectations, and coupled with relatively mild July inflation data, investors have lowered their expectations for further interest rate hikes, removing a key source of support for the dollar. The Consumer Price Index (CPI) and Producer Price Index (PPI) data released by the US Bureau of Labor Statistics this week showed that both consumer and industrial inflation grew slightly slower than market expectations. This type of data suggests that market expectations for the Fed to continue raising interest rates may cool further.

The final situation sees the dollar caught between two opposing forces: lower expectations for Fed rate hikes are bearish for the dollar, but any renewed surge in oil prices or continued disruption to shipping through the Strait of Hormuz will drive capital back into the dollar as a safe haven. Although the decline in Fed rate hike expectations has the potential to drag the dollar lower, safe-haven buying will limit the dollar's decline until the situation in the Strait of Hormuz becomes clearer. The bank has raised its one-month euro-dollar target to 1.15 (from a previous forecast of 1.14) and predicts that the exchange rate will likely fluctuate in the 1.15 to 1.16 range over the next 3 to 6 months.