The euro was steady at $1.1631, while sterling last bought $1.3546. The dollar index, which measures the U.S. currency against six of its key rivals, was at 98.75, close to its lowest level in almost two weeks.
OCBC strategists said the latest Middle East escalation keeps Federal Reserve policy implications from higher energy prices in focus, particularly after last week’s strong U.S. payrolls report revived expectations of a rate hike next week.
"For now, higher oil and yields may help limit USD downside, but we suspect a more decisive move will require confirmation from the upcoming inflation data," they said in a note.
Yen rally hinges on BOJ follow-through
The spotlight has been on the yen due to its 4% rise so far this month, shifting the calculus for the popular carry trade, in which investors borrow in yen at a low cost to invest in other currencies and assets offering higher yields.
The yen was firmer at 153.33 per U.S. dollar, close to the seven-month high of 152.89 that it hit on Tuesday. The rally has been broad-based, with the Japanese currency gaining against the euro and sterling, as well as popular carry-trade targets like the Mexican peso and Turkish lira.
The move has been fuelled by expectations for faster Bank of Japan tightening, the prospects of Japanese investors repatriating overseas funds and pressure from Washington for a stronger yen.
Traders widely expect the BOJ to raise rates by 25 basis points at its September 17 and 18 meeting, but the rally will hinge on whether Governor Kazuo Ueda follows through with hawkish comments. But the wild card will be the Fed.
"Much depends on the market’s pricing of the Fed’s trajectory of interest rates as well," said Aninda Mitra, head of Asia macro and investment strategy at BNY Investments.
"'Fair value' for the yen is in the 140s in our estimation and a further move toward that area should not entirely come as a surprise after, what has clearly been, an overshoot to the side of excessive yen weakness."
Claudio Wewel, an FX strategist at Bank J. Safra Sarasin, said the market's perception of the BOJ as slow-moving - a long-standing drag on the yen - appears to be dissipating.
But Wewel warned that headwinds persist, "including strong U.S. data, high energy prices, and concerns over the sustainability of Japanese debt, implying that the yen's rebound is built on shaky ground."
The Australian dollar rose 0.15% to $0.72265, just shy of the four-month high it touched in the previous session. The New Zealand dollar was 0.16% higher at $0.5862.
China's yuan was perched near a 3-1/2-year peak against the dollar as better-than-expected inflation data and quicker export growth buoyed the currency.
Yen steady as oil and Middle East tensions weigh on sentiment
The Japanese yen steadied near its strongest level since February on Wednesday, keeping the dollar on the defensive as traders grappled with oil prices pushing towards $100 per barrel in the face of a widening war in the Middle East.
Iranian-backed Houthis in Yemen launched strikes on several Saudi Arabian cities, further embroiling a U.S. ally in the conflict, while American forces hit multiple Iranian oil tankers and Tehran struck a U.S. base in Jordan.
That sent Brent crude futures up more than 1% to $99 per barrel, casting a shadow over global markets ahead of a U.S. inflation report on Friday that will set the stage for central bank meetings next week in the U.S. and Japan.
The dollar fell modestly, although some analysts attributed that weakness to the yen's rapid rise over the past week and investors positioning ahead of upcoming central bank meetings.
Later this week, the European Central Bank is broadly expected to increase interest rates on Thursday.
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