Q3 2026 FX Outlook: Currency Forecast for the US Dollar, Euro & Pound Sterling

Bondford’s Q3 2026 FX outlook examines the central bank policy decisions, inflation data and political developments shaping the currency markets. This quarter’s currency forecast looks at how a more hawkish Federal Reserve, a tightening European Central Bank and renewed political uncertainty in the UK are likely to influence the US dollar, euro and pound sterling over the coming months.

US Dollar: Resilient Fundamentals Meet Political Constraints

The US dollar ended Q2 2026 on a strong footing, rising to a one-year high against a basket of major currencies. Improved sentiment towards the US economy, easing concerns over the Middle East conflict, and a more hawkish Federal Reserve have combined to overcome much of the pessimism that surrounded the currency earlier in the year.

The Fed Reasserts Its Inflation Credentials

Perhaps the most significant development for the dollar came at the Federal Reserve's June meeting, the first chaired by President Trump’s nominee, Kevin Warsh. Prior to the event, investors questioned whether the new Chair would prove more willing to accommodate the White House’s demands for lower interest rates. Instead, Warsh delivered a firm defence of the Fed's inflation-fighting mandate, helping to reassure markets that monetary policy remains focused on economic fundamentals rather than politics.

The meeting also marked an important shift in expectations. While Warsh avoided providing explicit guidance on the future path of rates, projections from other FOMC members revealed growing support for further tightening. With inflation reaching 4.2% in May, markets have moved away from expectations of policy easing and are increasingly pricing the possibility of further tightening.

This matters because currency performance is driven by relative expectations. Only a few months ago, investors expected the European Central Bank to tighten while the Fed stood still. That gap has narrowed considerably, restoring support for the greenback.

Part of the market's adjustment also reflects a change in communication style under Kevin Warsh. Unlike recent Fed leaders, Warsh intends to provide significantly less forward guidance, arguing that excessive signalling can damage the Fed’s credibility and constrain flexibility. This shift may increase market volatility as investors become more reliant on incoming data rather than central bank guidance.

Economic Exceptionalism Endures

The dollar's recovery has been reinforced by continued resilience in the US economy. Despite elevated energy prices, trade tensions and geopolitical uncertainty, economic activity remains remarkably robust.

Jobs Data Continues To Outperform Expectations

Source: tradingeconomics.com

Labour market data has consistently exceeded expectations, consumer spending has remained resilient, and investor appetite for US assets shows little sign of fading. Record highs in US equity markets reflect continued confidence in sectors such as artificial intelligence and advanced technology, reinforcing one of the dollar's greatest structural advantages. While many advanced economies face stagnating productivity, the US continues to attract global capital by offering exposure to industries perceived as shaping the future.

S&P 500 Reaches New Highs

The conflict in the Middle East has also reinforced one of the dollar's structural advantages: the US is less exposed than many advanced economies to prolonged disruptions in global energy supplies, thanks to its greater energy independence and large domestic market.

Energy and Inflation Remain Unfinished Stories

The memorandum of understanding between the US and Iran has eased immediate fears of a prolonged disruption to global energy supplies. Oil prices have retreated from recent highs, and markets have become more optimistic that the worst-case economic scenarios can be avoided.

However, significant uncertainty remains. Questions persist over the durability of the agreement and the extent to which energy markets can normalise after months of disruption. For policymakers, this creates a difficult backdrop. A sustained decline in energy prices would reduce inflationary pressure and support growth, while renewed tensions could force the Fed to confront a more persistent inflation problem than currently anticipated, and expose itself to fresh pressure from the current administration.

Politics, Debt and the Limits of Dollar Strength

Despite the dollar's recent resurgence, several longer-term risks continue to temper enthusiasm.

Trade policy remains a major source of uncertainty. The Trump administration's continued pursuit of tariffs through alternative legal means when prior avenues get shut down has prolonged concerns about the impact on growth, business investment and inflation. At the same time, growing government borrowing requirements continue to place upward pressure on Treasury yields and raise questions about the long-term sustainability of US public finances.

Political uncertainty also remains elevated ahead of November's midterm elections, as the President’s weak approval ratings raise the possibility of the Republicans losing both chambers of Congress. While the US economy has so far demonstrated an impressive ability to absorb political shocks, investors remain sensitive to any developments that could undermine confidence in American institutions or worsen the fiscal outlook.

Bondford's Outlook

Bloomberg consensus forecasts suggest the dollar's recent resurgence may moderate over the coming year. While the currency has regained considerable ground in recent weeks, the consensus still anticipates modest depreciation against both the euro and the pound over the coming 12 months. That reflects the view that, although the US economy continues to outperform many of its peers and the Federal Reserve has adopted a more hawkish tone, political uncertainty, fiscal pressures and questions surrounding trade policy are likely to re-emerge as constraints on further dollar strength.

Several scenarios could emerge:

• Higher for Longer – Inflation remains persistent and the Fed resumes tightening. Strong growth and higher Treasury yields drive renewed dollar appreciation.

• Soft Landing – Energy prices stabilise, inflation gradually moderates and growth remains resilient. The dollar gives back some of its recent gains as markets become more confident that the Fed has reached, or is approaching, the peak in interest rates.

• Political Headwinds – Fiscal concerns, tariff uncertainty or renewed political tensions undermine investor confidence, accelerating the dollar's decline despite relatively strong economic fundamentals.

Summary

The dollar enters the second half of 2026 with momentum firmly on its side. Strong growth and a more hawkish Federal Reserve provide powerful support, but politics, debt and policy uncertainty continue to remind investors that America's greatest strengths are accompanied by equally significant risks.

Euro: Higher Rates Offer Support, but Structural Challenges Remain

The euro briefly regained some ground in Q2 2026, though that recovery has since unwound as the combination of a more hawkish Federal Reserve and a tentative easing of Middle East tensions restored support for the US dollar. As a result, the euro is now trading at its weakest level against the dollar since June 2025.

ECB Leads the Tightening Cycle

This newfound weakness has occurred despite the ECB delivering a 25bps rate increase in June. Although widely anticipated, the move nevertheless marked an important milestone as it made the ECB the first G7 central bank to tighten policy in response to the energy price pressures unleashed by the US-Iran conflict.

The decision reflected concerns that what began as an energy shock could become embedded in broader price and wage-setting behaviour. Eurozone inflation accelerated to 3.2% in May, its highest level since 2023, and policymakers judged that maintaining credibility around the 2% inflation target required a proactive response. Crucially, the ECB entered the crisis with interest rates already in neutral territory, giving it greater flexibility to act than its peers in the US and UK.

Will Rate Differentials Keep Narrowing?

The focus now shifts to what comes next. While ECB President Christine Lagarde struck a cautious tone during the June meeting, several policymakers have subsequently indicated that further tightening remains possible, even in the presence of a peace deal between the US and Iran. The ECB's latest forecasts reinforce this possibility. Inflation is projected to average 3.0% in 2026, up from 2.6% previously, while remaining above target at 2.3% in 2027.

The challenge for the euro is that the interest-rate story is no longer moving entirely in its favour. Expectations that the Fed would remain on hold or even cut have weakened following a notably hawkish June meeting, with Chair Warsh emphasising the importance of containing inflation. As a result, markets have become less convinced that Eurozone-US rate differentials will narrow in the months ahead, dulling the ability of the euro to draw support from higher European interest rates.

Energy Risks Still Loom

The recent memorandum of understanding between the US and Iran has provided some relief to global markets. Energy prices have retreated from their recent highs, equity markets have recovered and fears of an immediate escalation have eased. Yet it would be premature to suggest the agreement has removed uncertainty entirely. Given the lack of trust on both sides, questions remain over how durable the arrangement will prove, and any renewed disruption to energy supplies could quickly revive inflation concerns on both sides of the Atlantic.

This uncertainty is particularly important for the Eurozone. Unlike the US, it remains heavily dependent on imported energy, leaving it more exposed to sustained disruptions in global oil and gas markets. While stubbornly high energy prices strengthen the case for further ECB rate increases, they also weigh on growth, erode household purchasing power and worsen the region's terms of trade. This presents a difficult balancing act for the ECB in deciding what further action, if any, to take on interest rates, given how much uncertainty persists.

Growth Remains the Missing Ingredient

The weak growth backdrop remains one of the euro's principal challenges, raising the risk of a prolonged period of stagflation. Although increased defence spending and a somewhat more expansionary fiscal stance may provide support at the margin, they are unlikely to transform Europe's economic prospects in the near term. Compared with the US, the region continues to lack the same degree of dynamism in high-productivity sectors such as technology.

Fiscal risks also warrant close attention. Governments may feel compelled to continue shielding households and businesses from elevated energy costs through subsidies and support measures, while simultaneously increasing defence expenditure in response to a more uncertain security environment. For highly indebted member states, this raises the prospect of larger borrowing requirements at a time when sovereign debt markets are already absorbing substantial issuance globally. Should borrowing costs rise materially, concerns about debt sustainability could emerge as a headwind for the single currency.

Can the Euro Benefit from Relative Stability?

The euro's outlook will also be shaped by developments beyond the Eurozone. The approach of the US midterm elections, ongoing uncertainty over US economic policy and concerns about the country's fiscal outlook have encouraged some investors to reassess their exposure to dollar-denominated assets. While the dollar remains the world's dominant reserve currency, the euro is well placed to benefit should global investors continue to diversify their portfolios.

Relative political stability may provide an additional tailwind. Unlike the US and UK, where major political developments could influence market sentiment over the coming year, the Eurozone faces a comparatively quiet electoral calendar. Although the bloc continues to grapple with slow decision-making and policy fragmentation, the absence of significant electoral risks may nevertheless appeal to investors seeking greater predictability.

Even so, the dollar's recent recovery illustrates that periods of stronger US growth or heightened geopolitical uncertainty can still generate powerful support for the greenback.

Bondford’s Outlook

Bloomberg consensus forecasts point to a modest appreciation of the euro against both the dollar and the pound over the coming 12 months. This suggests that investors expect the dollar's recent resurgence to prove temporary, while the euro benefits from expectations that ECB policy will remain relatively restrictive, alongside relative political stability and a gradual easing of energy-market concerns. Even so, the projected gains are modest rather than dramatic, reflecting the continuing drag from weak growth, fiscal pressures and uncertainty over the durability of the US-Iran agreement.

Several scenarios could emerge:

• Fragile Peace – The ceasefire broadly holds, keeping energy prices contained and reducing inflation pressures. While this would support Eurozone growth, it could also lessen the need for further ECB tightening, limiting euro upside.

• Renewed Energy Shock – A breakdown in the agreement triggers renewed disruption in energy markets. Expectations of additional ECB tightening may provide some support, but weaker growth and deteriorating fiscal positions could ultimately weigh on the single currency.

• Fed-Led Dollar Strength – Inflation proves persistent in the US, prompting the Fed to raise rates alongside, or even ahead of, the ECB. Wider US yield support and safe-haven demand would likely favour the dollar and leave the euro struggling to gain traction.

Summary

The euro enters the second half of 2026 with opportunities, but little margin for error. Further ECB tightening, a relatively stable political backdrop and the euro's role as the world's second reserve currency offer support, but a more hawkish Fed, weak growth and lingering uncertainty over energy markets suggest that any recovery is likely to be gradual rather than straightforward.

Pound Sterling: Credibility Takes Centre Stage

Sterling ended Q2 2026 on a softer footing, pressured by a resurgent US dollar, renewed political uncertainty and shifting expectations for Bank of England policy. While the pound has avoided the sharp declines seen during previous periods of market stress, investors are once again asking familiar questions about the UK's fiscal outlook, growth prospects and economic direction.

Political Uncertainty Returns

The most immediate challenge facing sterling is renewed political uncertainty. Prime Minister Keir Starmer announced his resignation following a disappointing set of local election results for Labour, opening the door to a leadership contest at a time when global economic confidence remains fragile.

Much of the market's attention has centred on Andy Burnham, the former Mayor of Greater Manchester, whose recent by-election victory returned him to Parliament and made him eligible to contest the Labour leadership. Burnham is seen as the clear frontrunner should a formal contest take place. However, while he has built a strong political profile in local government, he has offered few indications of what his economic programme would look like at a national level. That absence of policy detail has become part of the uncertainty itself.

In the absence of clear policy signals, uncertainty tends to be priced first, with the details assessed later. For sterling, the key question is whether any leadership transition can be managed quickly and without raising doubts about fiscal discipline. Since the gilt market turmoil of 2022, investors have become far more sensitive to signs of fiscal slippage. Borrowing remains elevated, debt-servicing costs have risen and markets will be watching closely for signals on taxation, public spending and adherence to fiscal rules from any incoming administration.

A change of leadership may also complicate the UK's external relationships at a time when trade, defence and energy cooperation are increasingly important. Markets will be looking for reassurance that a new government can quickly establish constructive working relationships with both Washington and Brussels.

The Bank of England's Balancing Act

Monetary policy has also become more complicated. Only a few weeks ago, the escalation of the US-Iran conflict appeared likely to push the Bank of England towards a more hawkish stance as energy prices surged and inflation risks intensified.

Inflation Remains High, But Down on Prior Peaks

The subsequent memorandum of understanding between the US and Iran has altered that calculation. With oil prices retreating from their recent peaks, policymakers may feel more comfortable looking through what increasingly appears to be a temporary inflation shock.

This aligns with the Bank's broader concern that the UK economy remains fragile. Growth momentum has been weak, labour-market conditions have softened and policymakers have repeatedly highlighted downside risks to activity. As a result, markets have largely shifted from debating whether rates will rise to debating how long they will remain on hold. While a return to rate cuts remains possible later in the year, persistent inflation risks mean the Bank is unlikely to rush.

For sterling, this creates a difficult backdrop. The pound may prove relatively resilient against currencies facing similar monetary-policy dilemmas such as the Euro, but a more hawkish Federal Reserve leaves it vulnerable to renewed weakness against the dollar.

Growth Remains the Fundamental Constraint

Beyond politics and interest rates, the UK's subdued growth outlook remains sterling's biggest structural challenge. Productivity growth remains weak, business investment has been inconsistent and public finances leave limited room for significant fiscal stimulus.

Compared with the Eurozone, the UK retains some advantages in terms of labour-market flexibility and adaptability. Compared with the US, however, the gap in growth potential remains striking. While American markets continue to attract global capital through technology and innovation-led sectors, the UK has yet to identify a similarly compelling growth narrative.

Without stronger productivity growth, policymakers face increasingly difficult trade-offs between supporting the economy, controlling inflation and maintaining fiscal credibility.

Financing the UK's Deficits

Sterling's sensitivity to fiscal policy reflects a broader structural feature of the UK economy. The country continues to run sizeable fiscal and current account deficits, leaving it reliant on a steady inflow of foreign capital to finance both government borrowing and the wider economy.

This makes investor confidence particularly important. Should overseas investors begin to demand higher returns for holding UK assets, borrowing costs could rise and place renewed pressure on both gilt markets and sterling. Conversely, a credible fiscal framework backed by stronger growth would help preserve the UK's attractiveness to international capital.

Investors are therefore likely to judge any new government less by the size of its spending plans than by whether it can convince markets that stronger growth and sustainable public finances can be achieved together.

Bondford's Outlook

Bloomberg consensus forecasts suggest sterling will appreciate modestly against the dollar over the coming year, but underperform the euro. That reflects the UK's position between two competing forces: a domestic backdrop characterised by weak growth and political uncertainty, and an international environment in which the dollar is expected to relinquish some of its recent gains. Even so, the pound is not expected to match the euro's performance, as investors continue to view the Eurozone as offering a somewhat more supportive policy backdrop and greater political stability.

Several scenarios could emerge:

• Orderly Transition – Political uncertainty fades quickly, fiscal discipline is reaffirmed and the Bank of England remains on hold. Sterling stabilises and performs relatively well against the euro.

• Fiscal Credibility Tested – Markets become concerned about borrowing, spending plans or the direction of economic policy under a new leadership team. Gilt yields rise and sterling comes under pressure.

• Renewed Energy Shock – The ceasefire proves short-lived and tensions in the Middle East re-escalate. Rising energy prices push inflation higher and force markets to reassess the outlook for Bank of England policy. While expectations of higher interest rates could provide some support for sterling, the negative impact on growth and household finances would likely leave the pound vulnerable.

Summary

Sterling's outlook increasingly hinges on credibility. Political stability, fiscal discipline and clear policy direction could help the pound navigate a difficult global environment. Until those foundations are firmly established, however, investors are likely to remain cautious.

'This commentary reflects Bondford's views and should not be construed as representing the views of the author's employer or any other affiliated organisation'

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