The US dollar edged lower on Thursday after reaching its highest levels of the week, as the United States and Iran exchanged fresh military strikes. The move came despite the recent surge in oil prices, which reignited inflation concerns and reinforced expectations that the Federal Reserve could raise interest rates in the near term.

Inflation concerns and rate hike expectations keep markets on edge

Minutes from the Federal Reserve's June meeting, released on Wednesday, showed that policymakers left the door open to another interest rate hike this year, despite ongoing divisions over the timing of such a move.

Lee Hardman, currency strategist at MUFG, said in a note that if tensions in the region escalate further and oil prices continue to climb sharply, the dollar's recent upward momentum could strengthen, particularly after the Fed signaled its willingness to raise interest rates this year.

The dollar index fell 0.2% to 100.91, weighed down by a 0.2% rise in the euro to $1.1435.

Meanwhile, the Japanese yen edged higher but remained close to its weakest level in 40 years at 162.32 per dollar, a level that could prompt Japanese authorities to intervene in the foreign exchange market to support the currency.

The latest rise in oil prices, driven by the renewed exchange of attacks between the United States and Iran, continues to weigh on the yen, given Japan's heavy reliance on imported fuel and the pressure on its fiscal position.

Volatility across currency markets also increased noticeably during the week.

Kyle Rodda, senior financial market analyst at Capital.com, said the renewed tensions in the Middle East have once again unsettled global markets and restored the war-related risk premium across asset prices.

He added that the most significant indirect effect of higher oil prices is their impact on inflation and global interest rates, noting that a sustained rally in crude could accelerate the timing of the next US interest rate hike.

Markets raise odds of a rate hike to 87%

The US military announced on Wednesday that it had launched another round of strikes against Iran, hours after US President Donald Trump declared the temporary agreement to end the war "over," sending oil prices sharply higher.

Investors view the escalating rhetoric between the two sides as a warning sign that inflationary pressures could intensify, pushing the yield on the benchmark 10-year US Treasury note to its highest level in seven weeks and signaling growing expectations for another rate hike this year.

The minutes of the Federal Open Market Committee's June meeting, the first chaired by Kevin Warsh, also showed increasing concern among policymakers over inflation.

According to CME Group's FedWatch tool, markets have raised the probability of a Federal Reserve interest rate hike this year to around 87%.

In energy markets, Brent crude futures slipped to around $77 a barrel, down 1.5% during Thursday's session after surging more than 5% on Wednesday to their highest level in nearly two weeks.

Among other major currencies, the New Zealand dollar led gains, rising 0.7% to US$0.574 after the Reserve Bank of New Zealand raised interest rates the previous day and signaled that another increase remains possible if warranted.

The Australian dollar also rose 0.14% to US$0.694, while sterling gained 0.2% to US$1.342.