The dollar weakened sharply on Thursday, tumbling to its lowest point since May this year.

Federal Reserve Governor Christopher Waller said inflation has made some progress and noted that the September rate decision will depend heavily on next week's August inflation data, spurring markets to further trim their bets on a September rate hike by the Fed. Meanwhile, the yen appreciated about 2%, emerging as the strongest performer among G10 currencies, with rising expectations for a Bank of Japan rate increase and speculation over possible currency intervention jointly adding downward pressure on the dollar.

Dollar slides to lowest since May as Waller remarks dampen rate hike expectations

Data shows the Bloomberg Dollar Spot Index fell 0.6% on Thursday, marking its sharpest single-day drop in more than two weeks and touching its lowest level since May. A key catalyst for the dollar's weakness came from shifts in expectations for Fed policy.

Waller said Thursday that his next rate decision will be "significantly influenced" by the upcoming August inflation data. His comments about progress on inflation were viewed by the foreign exchange market as a relatively dovish policy signal. As a result, swap contracts tied to the Fed's September 16 rate decision show the market now prices in roughly a 50% probability of a 25-basis-point hike at that meeting. By contrast, earlier this week, markets had priced in around a 70% chance of a quarter-point increase in September. The notable cooling of rate hike expectations within just a few days has weakened a key interest rate factor that had been supporting the dollar.

Alex Cohen, a foreign exchange strategist at Bank of America, said: "Waller's speech today sent a dovish signal, pushing the dollar lower while markets moderately trimmed September rate hike expectations." He further noted that if upcoming U.S. employment or inflation data comes in soft, it could put even greater downward pressure on the dollar.

Yen jumps about 2% as BOJ rate hike expectations gain traction

Another major reason for the dollar's decline came from the yen's sudden sharp strengthening. On Thursday, the yen rose about 2% against the dollar, leading gains among G10 currencies. Investors are increasingly raising their bets on a Bank of Japan rate hike, while markets remain highly alert to the possibility that Japanese authorities may step in again to support the yen. The yen had long been pressured by the U.S.-Japan interest rate differential and Japan's fiscal outlook, but recent more hawkish policy signals from BOJ officials have prompted markets to reassess Japan's rate trajectory. At the same time, the yen's recent sharp volatility has kept currency traders on high alert, closely watching whether the Japanese government and central bank might take action to stabilise the exchange rate.

September Fed hike odds fall from about 70% to a coin flip

Market assessments of the Fed's September policy path have shifted notably in recent days. Earlier, with U.S. inflation pressures still elevated and Fed Chair Jerome Powell delivering hawkish signals at the Jackson Hole global central bank symposium, investors had clearly increased their bets on a September hike. But the latest economic data and remarks from Fed officials are now reshaping those expectations.

Waller said the August inflation data will have a major impact on his policy decision, implying that if inflation continues to cool, he may lean toward holding rates steady in September. Market pricing for a 25-basis-point hike in September has already fallen from roughly 70% earlier this week to about 50%, showing that investors no longer have a clear consensus on whether the Fed will continue tightening. This also makes the upcoming August inflation data a key catalyst for determining the dollar's next direction.

Markets turn to Friday's jobs report as employment data may set dollar's near-term course

Before the inflation data arrives, investors will first face Friday's U.S. monthly employment report. The importance of the jobs data lies in the fact that if the U.S. labour market shows further signs of cooling, the case for additional Fed rate hikes may weaken further. Earlier, the U.S. initial jobless claims data had already shown some softness, prompting markets to trim September hike bets. If Friday's jobs report again comes in weaker than expected, markets may further lower their expectations for a September hike, continuing to push down U.S. Treasury yields and the dollar. Conversely, if the labour market remains strong and the subsequent August inflation data comes in above expectations, rate hike expectations could regain momentum.

Diverging U.S.-Japan policy expectations put dollar facing key data tests

Overall, Thursday's sharp dollar decline was not driven by a single factor but resulted from the simultaneous cooling of Fed rate hike expectations and the heating up of BOJ rate hike expectations. Waller's assessment of inflation progress undermined market confidence in further Fed tightening in September, pulling the probability of a 25-basis-point hike from around 70% earlier this week down to a coin flip; meanwhile, rising bets on a BOJ move and market vigilance over potential currency intervention pushed the yen up about 2% against the dollar. Under this dual pressure, the Bloomberg Dollar Spot Index fell 0.6% to its lowest level since May.

Looking ahead, the dollar's trajectory will face two consecutive key U.S. economic data tests. First comes Friday's employment report, followed by next week's August inflation data. If both jobs and inflation show further cooling, markets may continue to reduce September rate hike bets and put more pressure on the dollar; on the other hand, any clearly stronger-than-expected data could reshape the current rate pricing.