The dollar extended gains on Tuesday as traders repriced Federal Reserve policy expectations following robust US services sector inflation, contrasting sharply with deteriorating economic momentum in Europe. The greenback's advance accelerated after Friday's ISM services price index jumped to its highest level since June, forcing market participants to reconsider assumptions about the Fed's easing cycle. "The market had gotten ahead of itself pricing aggressive Fed cuts in 2026," said David Kim, head of G10 FX strategy at Morgan Stanley. "This data reminds us that the last mile of disinflation remains challenging."
The euro faced sustained selling pressure after German industrial production contracted for a fourth consecutive month, reinforcing concerns that the currency bloc's manufacturing slump is deepening. European Central Bank officials have recently struck a more dovish tone, with Chief Economist Philip Lane suggesting last week that downside growth risks warrant "careful consideration." Money markets now price nearly 75 basis points of ECB cuts by mid-2026, widening the policy divergence with the Fed. Sterling also weakened after Bank of England Governor Andrew Bailey indicated the UK central bank could move "sooner rather than later" if inflation expectations remain anchored.
Geopolitical developments added complexity to currency moves, with crude oil prices surging amid reports of heightened security risks in the Strait of Hormuz. The Canadian dollar and Norwegian krone outperformed as energy exporters benefited from the price spike, while the Japanese yen drew modest safe-haven inflows. Bitcoin and other digital assets retreated as rising Treasury yields dampened appetite for riskier investments. "We're seeing a classic risk-off rotation, but it's selective," noted Lisa Rodriguez, senior market strategist at Brevan Howard. "Energy currencies are holding up while high-beta G10 pairs face pressure."
Positioning dynamics are amplifying moves as hedge funds unwind crowded trades heading into year-end. Technical strategists highlight that the dollar index has cleared key resistance levels that could trigger additional buying from momentum-driven algorithms. The focus now shifts to Wednesday's US consumer price report and Thursday's ECB policy decision, which traders say will either validate or reverse the emerging divergence theme. Meanwhile, month-end rebalancing flows are expected to create additional volatility, with model-based estimates suggesting moderate dollar selling from pension funds could offset some of the speculative buying.
Disclaimer: This analysis is AI-generated for educational purposes. Traders should verify all information and conduct their own research before making trading decisions.