Happy Monday. The dollar is trading near its strongest levels since last year’s ‘Liberation Day’ tariff debacle, and measures of implied volatility are climbing as long-term borrowing costs soar and fears of another sovereign-debt crisis stalk the euro area. Virtually every major currency is in an oversold technical position relative to the greenback, with most pairs trading almost 2% below their 200-day moving averages.

Last week brought a dovish repricing in expectations for US monetary policy. Throughout the week, Fed officials, including New York president John Williams. suggested policymakers needed more time to assess conditions, hinting that the next move might not come until December. On Wednesday, an update showed the Fed’s preferred gauge of underlying inflation, the core personal consumption expenditures index, rising by a smaller-than-expected 0.2% in August, decelerating from previous months. And on Friday, the non-farm payrolls report showed job creation softening, unemployment rising, and average hourly earnings growing at their slowest pace since May 2021, falling in real terms. Futures markets cut the odds on a rate hike at the central bank’s October 28 decision from more than 70% to less than 20%.

However, long-term yields kept rising, and there is no real consensus on why*. Shifts in expectations for inflation and growth, worries about debt and political risk have all been blamed. We think structural changes in bond markets are also partly at fault, with central banks and foreign official buyers stepping back, replaced by price-sensitive private investors and highly leveraged hedge funds. But yields are also tracking oil prices closely — far more closely than they are tracking inflation expectations***. That suggests investors believe central bank reaction functions have shifted, with policymakers now responding more to moves in oil benchmarks than to core price measures. After a series of public appearances from officials at the Fed, the European Central Bank, the Bank of Japan, and even the Bank of Canada, investors appear convinced that policymakers have abandoned decades of monetary orthodoxy and no longer intend to “look through” volatile commodity price moves when setting rates.

If Brent crude is now the world’s most important benchmark, it is showing little sign of easing. Although oil flows out of the Middle East have picked up, Iranian attacks have not stopped—at least seven vessels were hit last week—sending shipping costs soaring and adding $15–20 a barrel even before insurance premiums. Relief doesn’t seem imminent, with the Trump administration reported to be deploying 10,000 troops and a third aircraft carrier group, suggesting it may be preparing to escalate the conflict after the midterm elections. Brent is trading above $102 a barrel this morning, up almost 70% this year, and remains astonishingly volatile relative to history.

The euro, meanwhile, is trading near a 17-month low as turmoil in French bond markets deepens and rate differentials widen. With doubts growing over France’s ability to put its public finances on a sustainable footing, the spread between French and German ten-year yields briefly rose above 150 basis points on Friday, marking its widest since the euro-area debt crisis of 2011. The move is stoking fears of fragmentation, tightening financial conditions across the bloc and weighing on expectations of further rate hikes from the European Central Bank. We think those expectations have further to fall: With the wider euro area economy still weak, the risk of energy prices spilling over into core inflation looks low, so policymakers should deliver a final hike in December before moving onto the sidelines. Current pricing—for roughly three hikes by the end of next year—looks vulnerable.

But currency traders also risk over-interpreting the bond-market turmoil. If spreads were to widen in a disorderly way, the central bank would deploy its Transmission Protection Instrument, which lets it buy the bonds of countries whose borrowing costs rise unjustifiably. Bond investors, anticipating that, can be expected to respond almost reflexively, buying before the instrument is ever used. We think the common currency could find a floor well above the 1.10 threshold against the dollar as comparisons with the euro crisis are found lacking.

This week’s economic calendar should prove much less consequential. Although Wednesday’s minutes from the Fed’s September meeting will offer insight into the discussions that led to a surprisingly-unanimous quarter-point hike, investors are likely to discount some of the hawkishness given the tone of subsequent data. Thursday’s account of the European Central Bank’s September meeting, at which officials raised their inflation and growth forecasts, will be similarly downplayed, given how energy prices and sovereign bond yields have evolved since. And on Friday, the erratic nature of recent jobs reports should diminish the signalling value of Statistics Canada’s update on how the labour market has fared since the newest round of US tariffs took effect.

But conditions remain unusually perilous. With traders on edge, small shifts in oil prices, in policy expectations, or in the plumbing of markets could see exchange rates move violently. The disciplined use of market orders and options strategies could prove critically important at this juncture.

*You can, of course, find hundreds of articles and thousands of social media posts purporting to explain exactly what is happening. Be wary of explanations that lean on words such as “on,” “amid,” “as,” and “after”; that offer a laundry list of causes; that anthropomorphise price action, endowing markets with agency; or that rest on a single pundit’s observations rather than on quantifiable cross-asset data**.
**Also please don’t read my first paragraph.
***Note that market-implied inflation expectations have remained restrained for months.