The US dollar climbed to its highest level in more than a year on Tuesday as traders increasingly positioned for a more hawkish Federal Reserve policy outlook. The move came despite a modest decline in oil prices as tensions in the Gulf region eased, while the Japanese yen hovered near its weakest level in four decades.

Federal funds futures are now pricing in more than an 80% probability of an interest rate hike by September. Major financial institutions, including Bank of America Global Research and Deutsche Bank, have abandoned their previous forecasts for a steady policy stance and now expect the Federal Reserve to raise rates this year, citing the continued strength of the US economy.

"The dollar is currently reflecting expectations for higher interest rates, and it is gaining strength as a result," said Tommy von Brmsen, currency strategist at Handelsbanken.

He added: "The dollar is also benefiting from the fact that the conflict in the Middle East has not been fully resolved, leaving a significant degree of uncertainty that continues to support the US currency."

Euro and pound remain under pressure

The US Dollar Index, which measures the currency against a basket of major peers including the euro and yen, edged up to 101.13 points, its highest level since May 2025.

The euro fell to $1.1414, its weakest level since March, after European Central Bank President Christine Lagarde downplayed concerns about a second wave of inflation.

Meanwhile, sterling traded at $1.3234, slipping slightly on Tuesday after gaining in the previous session following the resignation of British Prime Minister Keir Starmer.

UK Health Secretary Wes Streeting, who had been viewed as a potential leadership contender, endorsed Andy Burnham as Starmer's successor, paving the way for a smoother leadership transition.

"One of the factors weighing on sterling had been uncertainty surrounding the leadership succession," said Commerzbank currency analyst Michael Pfister.

"With Streeting prepared to back Burnham, that uncertainty appears to be fading, allowing the pound to regain some strength," he added.

The Australian dollar, often viewed as a risk-sensitive currency, fell 0.8% to $0.6945, its weakest level since early April. The New Zealand dollar also declined about 0.5% to $0.5684.

Yen nears weakest level since 1986 amid intervention concerns

The Japanese yen traded at 161.48 per dollar after briefly weakening to a two-year low of 161.93 on Monday as the US currency continued to strengthen against major peers.

A move beyond 161.96 per dollar would push the Japanese currency to its weakest level since 1986.

"Volatility can be expected when the yen approaches these levels because the market anticipates that Japan may signal potential intervention or even carry out direct intervention," said von Brmsen of Handelsbanken.

A Reuters source said Japanese Finance Minister Satsuki Katayama held an online meeting with US Treasury Secretary Scott Bessent late Monday amid growing concerns over sharp currency market movements.

The discussions focused on possible policy measures to address the yen's historic weakness, including the possibility of intervention in the foreign exchange market.

Japanese financial authorities continue to keep markets guessing about the likelihood of intervention, with no clear signals suggesting any change in their communication strategy regarding the currency.