FOREX: Dollar rallies as oil prices surge, AI fears rattle markets

The U.S. dollar rose to a two-week high on Monday as conflict in the Middle East pushed up oil prices and sent investors towards the safe-haven currency, weighing particularly on the recently buoyant yen.

Warnings from frontier company CEOs about the possible dangers of AI weighed on stocks and also boosted the dollar, while rising bets on a Federal Reserve rate hike on Wednesday supported the U.S. currency.

The U.S. dollar index =USD, which tracks the currency against six major peers, was last up almost 0.5% to 99.59, its highest since September 2.

The euro EUR=EBS fell to a one-month low of $1.153, down more than 0.5%, while the British pound GBP=D3 fell 0.4% to $1.348.

A jump in oil prices unnerved investors and sent global bond yields back towards multi-year highs, with Brent crude LCOc1 up 3% to $108 a barrel.

Houthi strikes on the world's biggest exporter Saudi Arabia, which came after the kingdom shut down its main pipeline for bypassing the Strait of Hormuz, added to concerns about energy supplies.

Diplomacy over the U.S.-Iran war appeared to falter, with a meeting between Tehran and other Gulf governments postponed. Attacks on ships in the region compounded supply worries.

"Gulf developments remain concerning, and some AI-related headlines are further weighing on equities - an environment where the dollar should remain supported," said Francesco Pesole, currency strategist at ING.

The Japanese yen was a notable faller, giving up some of its recent sharp gains that have been driven by rising bets on Bank of Japan rate hikes.

The U.S. dollar was last up 0.7% against Japan's currency JPY=EBS at 154.61 yen, up from last week's almost seven-month low below 153.

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The key question for markets this week is whether the U.S. Fed will hike interest rates on Wednesday in response to the jump in energy prices that has pushed diesel to record highs and helped push up underlying inflation more than expected in August.

Money markets on Monday pointed to a roughly 90% chance of a rate hike, up from around 60% a week ago, according to CME Group's FedWatch tool.

"The U.S. dollar has strengthened modestly at the start of this week, encouraged by building expectations that the Fed will begin tightening monetary policy," said Lee Hardman, senior currency analyst at MUFG.

Yet Hardman said the Fed may be reluctant to hike rates too aggressively in an election year, potentially limiting the dollar's gains.

Rising bets on rate hikes around the world have pushed bond yields to multi-year or multi-decade highs in the U.S., Europe and Japan. So far the impact on the FX market has been relatively limited as yields have largely moved in tandem.

Markets are all but certain the Bank of Japan will raise rates on Friday and will be looking for clues on whether more increases are coming.

Signs are emerging of a shift in market sentiment for the yen, with speculators turning to a net long position on the yen for the first time since February.

The Bank of England is expected to keep borrowing costs on hold on Thursday but traders now expect a rate increase later this year and more in 2027, after the European Central Bank hiked last week.

-Reporting by Harry Robertson in London and Ankur Banerjee in Singapore; Editing by Edwina Gibbs and Andrew Cawthorne/Reuters