A sharp rise in oil prices has prompted traders to reduce their bets on Federal Reserve interest rate cuts this year, leading to a broad-based strengthening of the US dollar against all major currencies.

Following military strikes by the US and Israel against Iran over the weekend, the Bloomberg Dollar Spot Index climbed as much as 0.8%, reaching its highest level since early February. The effective closure of the critical Strait of Hormuz pushed oil prices to their largest single-day gain in four years. In response to the inflationary implications, swap traders now anticipate the Fed will cut rates by 56 basis points this year, down from 60 basis points projected last Friday.

Gareth Berry, a strategist at Macquarie Group in Singapore, commented, "If oil prices remain elevated and ultimately increase US inflationary pressures, this could be an early signal that the market perceives the Fed's willingness to cut rates as diminished. This is driving dollar strength, compounded by safe-haven flows, and is also contributing to a slight sell-off in US Treasuries."

The current rally extends the dollar's recovery in recent weeks, after it hit its lowest level since 2022 in January. The dollar's gains have been further supported by a decline in global equities, a flight to safety into gold, and a general deterioration in risk sentiment.

**Divergence in Options Markets** Activity in the options market suggests the dollar's strength is more closely linked to oil price dynamics than to traditional safe-haven demand. Traders are betting on the dollar to gain the most against currencies of major oil-importing nations like the euro and the pound, while its reaction against currencies of oil-exporting countries has been far more muted.

The pound fell as much as 1.3% to $1.3314, its lowest level this year, while the euro declined nearly 1%. In contrast, the Canadian dollar and the Norwegian krone saw only modest losses.

In a typical safe-haven-driven rally, the dollar strengthens uniformly. Therefore, the divergence between currencies indicates that energy costs are the primary driver, rather than broad-based panic. This dynamic is also visible in bond markets, with US Treasuries declining on Monday.

The crisis involving Iran may be re-activating the traditional correlation between the dollar and oil, given the US's status as a net energy exporter. On Monday, the correlation between the two turned positive for the first time in three months.

Jordan Rochester, Head of Fixed Income, FX, and Commodities Strategy for EMEA at Mizuho Bank, stated, "The playbook from the early stages of the Ukraine crisis will be reapplied to FX and rates markets. If oil prices remain at current levels or higher, this constitutes a terms-of-trade shock, reviving old dollar correlations that have been dormant for a year."