Euro holds firm as traders assess geopolitical risks and interest rate outlook

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EUR/USD holds modest gains on Thursday, supported by some softness in the US Dollar (USD) as markets assess renewed hostilities in the Middle East. At the time of writing, the pair trades around 1.1444, up 0.25% on the day.

EUR/USD holds modest gains as a softer US Dollar offers support.
US-Iran tensions revive energy-driven inflation risks.
Upcoming inflation data could shape the ECB's and the Fed's next policy moves.

The latest escalation between the United States (US) and Iran has failed to provide a strong boost to the US Dollar. At the same time, downside in the Greenback has remained limited, reflecting market uncertainty over whether the interim peace agreement between Washington and Tehran will hold or collapse.

The US Dollar Index (DXY), which tracks the Greenback against a basket of six major currencies, trades around 100.90 after touching an intraday low of 100.79.

Meanwhile, energy-driven inflation risks are back at the forefront as Oil prices rebound on growing security concerns around the Strait of Hormuz, a critical chokepoint that handles about 20% of global Oil flows.

As a result, traders are increasingly expecting central banks to tighten monetary policy. Markets anticipate another European Central Bank (ECB) interest rate hike later this year, while the CME FedWatch Tool shows a 63% probability of a Federal Reserve (Fed) rate hike at the September meeting.

Minutes from both the ECB's and the Fed's June meetings showed policymakers remained concerned about upside risks to inflation. Traders will closely watch next week's inflation data from both sides of the Atlantic as they look for fresh clues on the next policy moves.

New York Fed President John Williams said on Thursday, "Inflation is still far too high," adding that the Fed is "actively debating scenarios around inflation" and remains committed to bringing inflation back to its 2% target.

Inflation FAQs

What is inflation?

Inflation measures the rise in the price of a representative basket of goods and services. Headline inflation is usually expressed as a percentage change on a month-on-month (MoM) and year-on-year (YoY) basis. Core inflation excludes more volatile elements such as food and fuel which can fluctuate because of geopolitical and seasonal factors. Core inflation is the figure economists focus on and is the level targeted by central banks, which are mandated to keep inflation at a manageable level, usually around 2%.

What is the Consumer Price Index (CPI)?

The Consumer Price Index (CPI) measures the change in prices of a basket of goods and services over a period of time. It is usually expressed as a percentage change on a month-on-month (MoM) and year-on-year (YoY) basis. Core CPI is the figure targeted by central banks as it excludes volatile food and fuel inputs. When Core CPI rises above 2% it usually results in higher interest rates and vice versa when it falls below 2%. Since higher interest rates are positive for a currency, higher inflation usually results in a stronger currency. The opposite is true when inflation falls.

What is the impact of inflation on foreign exchange?

Although it may seem counter-intuitive, high inflation in a country pushes up the value of its currency and vice versa for lower inflation. This is because the central bank will normally raise interest rates to combat the higher inflation, which attract more global capital inflows from investors looking for a lucrative place to park their money.

How does inflation influence the price of Gold?

Formerly, Gold was the asset investors turned to in times of high inflation because it preserved its value, and whilst investors will often still buy Gold for its safe-haven properties in times of extreme market turmoil, this is not the case most of the time. This is because when inflation is high, central banks will put up interest rates to combat it. Higher interest rates are negative for Gold because they increase the opportunity-cost of holding Gold vis-a-vis an interest-bearing asset or placing the money in a cash deposit account. On the flipside, lower inflation tends to be positive for Gold as it brings interest rates down, making the bright metal a more viable investment alternative.