Q4 2026 FX Outlook: Currency Forecast for the US Dollar, Euro and Pound Sterling

US Dollar Outlook Q4 2026: Higher Rates Meet Higher Political Risk

The US dollar enters Q4 with momentum, buoyed by a sharp recalibration of interest rate expectations. The Federal Reserve's 25bp rate hike in September (its first since 2023) and the prospect of further tightening have restored one of the dollar's most important sources of support: an interest rate advantage over other major economies.

The move also represents an important test for new Fed Chair Kevin Warsh, appointed in May as President Trump's preferred successor to Jerome Powell. After months of speculation over whether the new regime would be inclined to lower rates, the Fed instead delivered a unanimous decision to tighten. The question now is whether September's hike marks the beginning of a sustained tightening cycle, or whether the Fed has simply shown that it is willing to raise rates when its credibility is on the line.

The Fed Reasserts Its Inflation Credentials

The case for higher rates is becoming harder to ignore. Inflation remains well above the Fed's 2% target, most recently at 3.4% in August, while the energy shock stemming from the conflict with Iran threatens to prolong inflationary pressure.

Diesel prices above $6 per gallon are particularly concerning. Diesel is critical to freight, agriculture and manufacturing, meaning higher fuel costs can feed rapidly into prices across the wider economy. The persistence of tariff-related price pressures adds another complication. At the same time, the labour market has proved more resilient than expected. Non-farm payrolls increased by 162,000 in August, far exceeding expectations of just 55,000, while unemployment held at 4.1%.

August’s upside surprise in NFP help set the stage for the September rate hike

Source: tradingeconomics.com

The broader economy is less spectacular than the headline numbers might suggest. GDP growth slowed to an annualised 1.5% in Q2, from 2.1% in Q1. However, private domestic demand remained considerably stronger, while investment and productivity have benefited from the US corporate race for AI supremacy. US equities have also continued to attract international capital, providing another source of dollar demand.

Taken together, the economy is simply not showing the weakness that would normally justify monetary easing. The Fed's hawkish turn was becoming increasingly difficult to resist.

Warsh Changes the Rules

That does not mean the path ahead is straightforward.

Warsh has made it clear that he wants to reduce the Fed's reliance on traditional forward guidance, arguing that policymakers can become constrained by signalling their intentions too far in advance. The approach gives the Fed greater flexibility, but makes it harder for markets to establish a clear path for interest rates.

That uncertainty could become increasingly important for the dollar. The September ‘dot plot’ still points towards at least one further hike, but Warsh has insisted that future decisions will depend on incoming data rather than a predetermined path. The Fed may have shown its hand in September, but it has not shown all of its cards.

For now, however, the Fed has at least passed its first major credibility test. The unanimous rate increase suggests that the Fed remains willing to prioritise price stability despite the political pressure surrounding monetary policy.

That contrasts with the policy debate elsewhere. The ECB is also facing inflationary pressure from the energy shock, while the Bank of England faces the difficult combination of persistent inflation and precarious growth. The relative response of the major central banks will therefore be crucial for the dollar over the coming quarter.

The Dollar's Safe-Haven Status Faces Scrutiny

Higher US rates and strong corporate performance would normally provide a powerful combination for the dollar. Yet the dollar's gains have been surprisingly restrained.

Part of the explanation lies in concerns over US fiscal policy and the Treasury market. The US government debt burden has passed $40 trillion, while long-term Treasury yields have reached their highest levels in decades. Treasury Secretary Scott Bessent responded by increasing the size of the government's long-dated bond buyback programme, but the intervention did little to reassure investors, who are far more concerned about underlying pressures from large fiscal deficits, elevated inflation and heavy Treasury issuance than claims about liquidity.

The dollar and US government bonds have long benefited from their status as the world's premier safe-haven assets. The question is whether that status can survive a period in which investors increasingly see US policymakers themselves as a source of market risk.

Trump’s declining approval rating presents a challenge for Republicans in the mid-terms

The upcoming midterm elections provide a further test. A change in the balance of power in Congress could constrain the administration's ability to pursue its economic agenda, potentially resulting in political gridlock. Conversely, continued unified Republican control could give the administration scope to expand its existing contentious policies on tariffs, fiscal spending and regulation.

Neither outcome provides a straightforward dollar signal. Markets will instead have to assess what the result means for inflation, government borrowing, trade policy and confidence in US institutions. You can read more about it in our article here: https://bondford.com/insights/us-midterms-2026-dollar-outlook

Bondford's Outlook

The current Bloomberg consensus suggests that the dollar may struggle to maintain its recent advantage against both the euro and pound over the coming year. The immediate outlook, however, is dependent on three related scenarios.

Several scenarios could emerge:

• A Fed reversal – The dollar's recent momentum rests heavily on the prospect of rates staying higher for longer. A convincing fall in inflation or deterioration in the labour market could quickly revive expectations of easing, narrowing the US rate advantage.

• Iran and oil de-escalation – A reduction in geopolitical tensions would be positive for the global economy, but less helpful for the dollar. Lower energy prices would reduce US inflation and weaken the case for further Fed tightening, while removing some of the safe-haven demand generated by the conflict.

• Political and fiscal uncertainty – he midterms could alter the balance of power in Washington just as concerns over US debt and elevated long-term Treasury yields are intensifying. A divided Congress could make further tax cuts or spending increases harder to deliver, while continued uncertainty over tariffs, borrowing and economic policy could weigh on investor confidence. Either way, the election introduces another source of uncertainty at a time when the dollar's traditional safe-haven advantages are already being questioned.

Summary

The dollar enters Q4 with stronger monetary fundamentals than it had just a few months ago. A resilient labour market, persistent inflation and a more assertive Federal Reserve provide solid support. But higher rates may not be enough to overcome growing questions about US fiscal policy, political stability and the durability of America's safe-haven premium. For the dollar, the coming quarter may therefore be less about whether the US has the strongest fundamentals, and more about whether investors still believe those fundamentals outweigh the risks created by Washington itself.

Euro Outlook Q4 2026: Political and Energy Headwinds

The ECB Has Found Its Hawkish Voice

By the end of Q3, the euro had surrendered much of the ground it gained ahead of September's ECB meeting. The 25bp rate hike, the second this year, had been widely anticipated as inflation returned to the forefront amid the Middle East energy shock. Under normal circumstances, another rate increase and a more hawkish ECB should have supported the euro. Instead, its gains were quickly undermined by the Federal Reserve's hawkish turn just days later, as the prospect of further US tightening reduced the scope for narrowing interest rate differentials.

The question for the euro is therefore not simply whether the ECB will keep tightening, but whether it can tighten quickly enough to stop the US from reclaiming the interest rate advantage.

Growth Is Holding Up — For Now

The eurozone economy is at least giving the ECB some room to manoeuvre. GDP growth surprised on the upside in Q2, rising 0.6% quarter-on-quarter after stagnating in Q1. Employment also increased, while the ECB has raised its 2026 growth forecast to 0.9%, citing greater-than-expected economic resilience. The recovery has been supported by stronger exports, investment in technology and AI, and increased government spending, particularly on defence and infrastructure.

But this should not be mistaken for an economic boom. The eurozone remains exposed to weak competitiveness, trade uncertainty and higher energy costs. Its recent resilience reflects an economy that has absorbed a series of shocks better than expected, rather than one operating at full strength.

Inflation Has Become the ECB's Problem Again

For policymakers, inflation is now the more immediate concern. After spending much of 2025 close to the ECB's 2% target, eurozone inflation accelerated to 3.3% in August, its highest level since 2023. Energy inflation surged to 14.3%, while core inflation (excluding energy and food) remained considerably lower at 2.4%.

The distinction is important. Europe's inflation problem is being driven primarily by the energy shock rather than a broad-based acceleration in domestic prices. Yet the energy outlook remains uncomfortable. Europe is entering the winter with gas storage well below its five-year average, while natural gas and oil prices have risen sharply as the conflict in the Middle East disrupts energy markets.

The risk is that an initially temporary energy shock becomes embedded more widely across the economy. Higher fuel costs feed into transport, agriculture and manufacturing, meaning Europe's energy vulnerabilities can turn an external shock into a domestic inflation problem very quickly. For now, wage growth has remained relatively contained at 3.3%, suggesting limited evidence that the shock is feeding into a broader wage-price spiral. That could change if elevated inflation persists, leaving the ECB with little room for complacency.

Europe's Political Risk Premium

The euro could also have benefited from political uncertainty in the US by offering investors an alternative destination for capital. Instead, Europe has developed political and fiscal risks of its own.

France is the clearest example. The country is struggling to reduce a large budget deficit ahead of the 2027 presidential election, where the prospect of a populist victory adds to uncertainty over the future direction of fiscal policy. The spread between French and German 10-year bond yields has subsequently risen above 100 basis points for the first time since 2012, reflecting increased investor concern over France's fiscal and political outlook.

Meanwhile, Germany, traditionally the eurozone's fiscal and economic anchor, is facing a different political challenge. Electoral gains by the AfD have increased pressure on Friedrich Merz's centrist coalition, complicating the political backdrop for the government's much-needed spending and reform programme. German 10-year yields have also risen to their highest level since 2009.

The problem for the euro is not that France and Germany face political challenges. It is that both are becoming less predictable at a time when investors are demanding greater certainty from European policy. With the US and China increasingly competing for economic and strategic influence, political fragmentation risks making it harder for Europe's two largest economies to agree on how to respond.

ECB: How Far Can It Follow the Fed?

The ECB has raised rates twice this year, taking its deposit rate to 2.5%, but it remains well below the Fed's 4% and the Bank of England’s 3.75%. There is a credible case for further ECB tightening: inflation is expected to remain above target and the economy has demonstrated newfound resilience. But the central bank must also consider the impact of higher borrowing costs on heavily indebted governments and an economy already facing higher energy prices.

The euro is therefore highly dependent on relative interest rate expectations. It may hold its ground against sterling if the ECB remains more hawkish than the Bank of England, but if US rates stay higher for longer, the euro will struggle to reproduce its earlier gains against the dollar.

Bondford’s Outlook

Bloomberg consensus forecasts currently point to further euro appreciation over the coming 12 months, with it reaching around $1.18 against the dollar and €0.88 against sterling. That outlook, however, depends heavily on the evolution of interest rates, energy prices and Europe's political landscape.

Three potential scenarios stand out:

• ECB Keeps Tightening – Inflation remains elevated and the ECB continues raising rates. This would provide an important source of support for the euro, particularly against sterling.

• Energy Shock Fades – Iran-related disruption eases, oil and gas prices retreat and inflation expectations fall. The ECB would have less need to tighten, reducing the euro's rate advantage, but improving growth prospects.

• Political Risk Escalates – French fiscal concerns intensify, German political fragmentation increases and sovereign spreads widen further. The ECB would face a difficult choice between maintaining restrictive policy and containing financial stress.

Summary

The euro enters Q4 with a stronger economic and monetary backdrop than many expected. Growth has surprised on the upside and the ECB has shown that it is prepared to keep tightening as inflation remains well above target. But the currency faces a difficult combination of stronger US rate expectations, rising energy costs and growing political and fiscal uncertainty across the eurozone.

For the euro, the coming quarter may therefore be less about whether the ECB is hawkish enough, and more about whether it can remain hawkish without exposing the vulnerabilities that higher rates, energy costs and political fragmentation are beginning to reveal.

Pound Sterling Outlook Q4 2026: Caught Between Rates and Risk

Sterling had a strong run in the middle of Q3 based on a relatively simple premise: stronger-than-expected UK growth was driving expectations for interest rates higher. That story has since become more complicated. The Bank of England held rates at 3.75% in September while the Federal Reserve and ECB tightened, pulling the currency back to a near seven-week low. Yet markets still expect the BoE to raise rates, with around a 65% chance of a hike in November, and almost four 25bp increases priced through 2027.

The question for sterling is not simply whether UK rates will rise, but whether the economic and fiscal consequences of higher rates will eventually outweigh their support for the currency.

Growth Is Holding Up — But Inflation Is Back

The UK economy has entered Q4 with more momentum than expected. GDP grew by 0.6% in Q1 and 0.4% in Q2, while monthly GDP increased by a further 0.4% in July. Consumer spending has also shown resilience, with retail sales beating expectations in August, while unemployment has remained broadly stable at around 4.9%.

At first glance this gives the BoE some room to tighten without immediately threatening a recession. But the recent economics strength may not prove durable. Higher energy costs this winter are set to squeeze household incomes and business margins, while some of the recent momentum may simply reflect outsized technology investments and temporary factors rather than a broad-based acceleration in underlying demand.

Unexpectedly strong UK growth in H1 2026

At the same time, inflation is firmly moving in the wrong direction. CPI rose to 3.1% in August, with the BoE estimating that around 0.7 percentage points of the overshoot above its 2% target came directly from energy, predominantly motor fuel. Based on current trends in wholesale energy markets, the Bank expects inflation to rise above 4% in early 2027.

That leaves policymakers facing a familiar but uncomfortable problem: how much of the external energy shock should the BoE look through, and when does it become dangerous to do so?

The BoE's Dilemma

The September MPC vote captured the debate. Six members, including Governor Andrew Bailey, voted to hold rates, while three voted for an immediate 25bp increase. The divide is less about whether inflation is a problem than about how quickly and forcefully policymakers should respond.

The three dissenters are concerned that stronger reported economic activity and a long-lasting energy shock will allow inflation to feed into wages, exacerbating the potential price problem unless it is tackled now. The majority, meanwhile, point to already restrictive financial conditions, a soft labour market and the lack of these meaningful second-round effects observed so far. The OECD has taken a similarly cautious view, arguing that the energy shock can be looked through provided consumer expectations of inflation remain anchored.

The longer the Middle East conflict persists, however, the harder that argument becomes to sustain. The Bank has so far seen limited evidence that higher energy costs are feeding through more broadly, but there is a limit to how long businesses can absorb higher costs before passing them on to consumers. If that begins to happen just as wage negotiations respond to higher inflation, the Bank could find itself needing to tighten more aggressively later to prevent inflation becoming entrenched.

This is the critical test for sterling - whether the BoE responds credibly enough to prevent a temporary energy shock from becoming a more entrenched inflation problem. If it does, higher rates could provide sterling with an important interest-rate advantage. If the shock fades and underlying inflation remains contained, the Bank could resist current market expectations, removing that support.

The Bigger Risk May Be Fiscal

Monetary policy, however, is only half of the equation. Higher interest rates may support sterling when they reflect credible efforts to control inflation, but they also increase the cost of servicing Britain's large public debt, putting additional pressure on the government's finances.

That pressure is already visible. Public sector borrowing unexpectedly surged to £18.3bn in August, while higher gilt yields and inflation have cut the government's fiscal headroom from around £24bn at the last budget to roughly £10bn. The government will therefore enter the 28 October Budget with limited room to meet its spending commitments while adhering to its fiscal rules.

This creates a difficult balancing act for newly installed Prime Minister Andy Burnham and his Chancellor John Healey. To seize the initiative, the government needs to support growth and fund commitments on areas such as housing and social care, while convincing investors that the public finances remain under control. Raising taxes can help close the gap, but risks weakening an already fragile economy, and businesses are still reeling from the tax hikes of the previous two Budgets. Cutting spending, meanwhile, is politically difficult given the priorities of backbench Labour MPs; and weakening the fiscal rules to allow more borrowing could undermine confidence in the government's commitment to debt sustainability.

The gilt market is already sending a warning. Thirty-year borrowing costs recently reached their highest level since 1998 and are among the highest in the G7 (although yields subsequently fell after the BoE announced a pause in active sales of long-dated gilts at its September meeting).

Sterling will, nonetheless, be highly sensitive to which of these forces driving rates higher takes the lead. Higher yields caused by expectations of tighter monetary policy and stronger growth can support the pound. But if yields rise because investors are demanding compensation for fiscal risk or persistent inflation, they can quickly become a source of weakness. The October Budget will therefore be an important test of whether Britain's rising borrowing costs remain a monetary-policy story, or become a fiscal one.

Bondford’s Outlook

Current Bloomberg consensus forecasts suggest the pound will continue to lose ground against the euro over the next 12 months, falling to around €1.14, while recovering some of its recent losses against the dollar to reach $1.35. These forecasts are highly sensitive to the assumptions behind them, however, with monetary policy, fiscal decisions and the fragile geopolitical backdrop all capable of shifting the outlook. Three scenarios stand out:

Several scenarios could emerge:

• BoE Tightens Faster – Energy inflation persists and second-round effects emerge. The BoE raises rates towards current market expectations, restoring sterling's interest-rate advantage.

• Inflation Proves Temporary – Energy prices fall, underlying inflation remains contained and labour-market weakness becomes more important. The BoE raises rates less than markets expect, removing some support for sterling while allowing growth to recover.

• Budget Undermines Fiscal Confidence – The government struggles to reconcile its spending commitments with its fiscal rules, pushing gilt yields higher for the wrong reason and putting renewed pressure on sterling.

Summary

Sterling entered the quarter with a respectable fundamental story: growth has surprised positively and the threat of persistent inflation was keeping the BoE leaning hawkish. But the same energy shock that could force the Bank to raise rates is also raising borrowing costs and squeezing an already constrained fiscal position.

The October Budget and November MPC meeting will therefore provide two closely linked tests of UK policy credibility. If markets conclude that Britain can control inflation while maintaining fiscal discipline, sterling can regain an advantage. If either side of that equation starts to look doubtful, higher yields could instead signal growing concerns over Britain's economic and fiscal outlook.

'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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