The US dollar traded in volatile fashion on Monday after surrendering its early gains, as investors focused on renewed military clashes in the Gulf region. Meanwhile, the Japanese yen weakened following a report indicating that Japan has no immediate plans to alter the asset allocation of its government pension funds.

The dollar initially strengthened alongside higher oil prices before losing momentum later in the session. The euro rose 0.15% to $1.1433, sterling was little changed at $1.339, while the Australian dollar slipped 0.1% to $0.694.

Renewed Gulf tensions lift oil prices

The weekend saw an intense exchange of missile and drone attacks between the United States and Iran. Tehran targeted US facilities in several Gulf countries on Sunday and once again announced the closure of the Strait of Hormuz, one of the world's most important oil shipping routes.

The developments pushed oil prices higher, with Brent crude rising about 3% to $78.50 a barrel.

In currency markets, the US dollar index, which measures the greenback against a basket of six major currencies, climbed as much as 0.3% during the session before reversing course to trade down 0.2% at 100.83.

"The dollar was the biggest beneficiary of the previous conflict, but this time it is starting from a much stronger level, and markets have already repriced their expectations for Federal Reserve policy," said Thomas Mathews, Head of Markets for Asia-Pacific at Capital Economics.

"So it is not clear that the dollar will enjoy the same gains if the situation continues to deteriorate, and that already appears to be reflected in today's price action," he added.

Markets increase bets on US rate hikes

Federal funds futures showed that markets are pricing roughly a 50% probability that the Federal Reserve will raise interest rates two or more times by its December meeting, up slightly from Friday, according to CME Group's FedWatch tool.

This week's focus will be on:

US Consumer Price Index (CPI) data due on Tuesday.

US Producer Price Index (PPI) data scheduled for Wednesday.

Testimony by Federal Reserve Chair Kevin Warsh before both the House of Representatives and the Senate, which could provide fresh signals on the future direction of monetary policy.

Yen weakens again

The Japanese yen declined against the US dollar after a report indicated that the Japanese government has no immediate plans to revise the asset allocation of government pension funds.

The dollar rose 0.2% to 162.05, reviving concerns that Japanese authorities could intervene in the foreign exchange market as the yen continues to trade near its weakest level in almost 40 years.

The yen and Japanese government bonds had rallied on Friday after Finance Minister Satsuki Katayama said the government would explore ways to encourage pension funds, including the Government Pension Investment Fund (GPIF), to increase investments in domestic financial assets.

However, two government sources told Reuters that the administration is only seeking to encourage investment within the current asset allocation framework, with no immediate plans to revise the fund's medium-term allocation targets.

Chris Turner, Global Head of Markets at ING, said the possibility of Japanese intervention in the currency market remains on the table this week, but noted that "intervention alone cannot reverse the dollar's current upward trend."

He added that reversing the trend would require lower energy prices as well as greater confidence that the Federal Reserve no longer needs to continue raising interest rates.