The yen, meanwhile, remained close to a seven-month high against the dollar, reflecting growing expectations that the BOJ could accelerate the pace of monetary tightening. The currency has gained about 4% this month as traders increasingly position for further Japanese rate increases and possible repatriation of overseas assets by domestic investors.
Market sentiment was also being clouded by sharply higher oil prices as the war in the Gulf intensified, adding a fresh inflationary threat to economies already struggling with volatile price pressures.
Brent crude futures climbed nearly 3% to about $107.60 a barrel after new Houthi strikes on Saudi Arabia and Iranian attacks on vessels in the Gulf heightened fears over supplies. Concerns were further aggravated by the closure of a key Saudi oil pipeline.
The surge in energy prices has complicated the outlook for monetary policy worldwide. Policymakers are now attempting to assess whether higher oil costs will produce a temporary inflation shock or a more persistent increase in consumer prices that could require additional interest-rate increases.
The latest market moves come after the European Central Bank raised interest rates last week and signalled that further increases could follow. Attention has now shifted to the Federal Reserve, which is due to announce its policy decision on Wednesday, followed by the Bank of Japan on Friday.
The Bank of England is expected to leave rates unchanged on Thursday, although the vote could be closely contested.
Fed Faces Inflation Test
Expectations for a Federal Reserve rate increase strengthened after U.S. data released on Friday showed consumer prices accelerating in August. According to the CME FedWatch tool, traders were pricing in an 86% probability of a rate increase this week, with another move also anticipated later in the year.
The outlook presents a difficult choice for the Fed as it attempts to contain inflation without putting excessive pressure on economic growth and financial markets.
"The Fed could decide to wait, but that is complicated by its October meeting being just ahead of the U.S. midterm elections and waiting until December to move will be too long," said Shane Oliver, chief economist and head of investment strategy at AMP.
The U.S. dollar index, which measures the greenback against six major currencies, rose 0.12% to 99.22 on Monday after recording modest declines in each of the previous two weeks.
The euro slipped 0.1% to $1.1585, while sterling was last trading at $1.3516.
U.S. Treasury yields also remained elevated. The two-year Treasury yield, which is particularly sensitive to expectations for Federal Reserve policy, edged down to 4.6148% after jumping 26 basis points last week.
Despite the rise in Treasury yields and stronger expectations for U.S. rate increases, the dollar has so far failed to make a decisive advance. One reason is that other major central banks are also expected to tighten policy, narrowing the relative advantage of U.S. interest rates.
Concerns about the Federal Reserve's credibility in its fight against inflation have also complicated the dollar's outlook.
Strategists at Commonwealth Bank of Australia said Fed Chair Kevin Warsh would need to align his policy actions with his recent tough stance on inflation or risk further damaging the central bank's credibility.
"There is a small chance the USD eases if the FOMC hikes but Warsh plays down the risk of follow-up hikes in the press conference," the strategists said in a note.
Yen Gains Momentum Ahead of BOJ Meeting
Japan's currency has emerged as one of the major stories in global foreign exchange markets this month.
The yen weakened 0.3% to 154.03 per dollar on Monday but remained within sight of the seven-month high of 152.89 reached last week.
The currency's recent strength reflects growing conviction that the BOJ is moving toward a more aggressive normalization of monetary policy following years of ultra-loose conditions.
Speculators have also shifted to a net long position in the yen for the first time since February, providing another indication that market sentiment toward the currency is changing.
A 25-basis-point increase by the BOJ is now widely expected.
"A 25 bps hike is already almost fully priced," analysts at MUFG said in a note. "For the yen to strengthen further, the BOJ will have to signal that they are planning to stick to the faster pace of hikes."
The scale of the yen's recent appreciation means investors will be watching not only the BOJ's decision but also its guidance on future increases.
TD Securities analysts warned that if the central bank fails to keep another rate increase on the table for either its October or December meeting, the yen could quickly reverse course.
Such a move, they said, could trigger a sharp rally in the dollar against the yen, potentially pushing the exchange rate back toward 157 to 160 yen per dollar.
The analysts expect the BOJ to raise rates approximately once every quarter, marking a departure from its previous, more gradual approach of moving roughly every six months.
Oil Shock Adds to Policy Dilemma
The currency-market turbulence is unfolding against a backdrop of mounting concern over the global economic impact of the conflict in the Gulf.
Oil prices have surged above $100 a barrel as the six-month-long U.S.-Israeli war on Iran has disrupted expectations for energy supplies and introduced another major source of inflationary pressure.
The increase in crude prices has complicated the decisions facing central banks. Higher energy costs can push inflation upward even as tighter monetary policy weighs on demand and economic activity.
At the same time, the sharp moves in oil and bond markets have contributed to bouts of selling in longer-dated government debt, creating additional volatility across global financial markets.
For Japan, the BOJ's decision carries particular importance because of the yen's recent rally and the potential impact of higher domestic interest rates on capital flows.
James Athey, fixed-income portfolio manager at Marlborough, said the central bank could face significant market consequences if it fails to deliver either a rate increase or sufficiently strong guidance.
"Not hiking would be a catastrophic error. Not communicating robustly will be a significant own goal," said James Athey, adding that expectations about repatriation and GPIF asset allocation changes are playing a significant role in the yen move.
With the Federal Reserve and BOJ decisions arriving within days of each other, investors are preparing for potentially sharp moves across currencies, bonds and commodities. The combination of higher oil prices, renewed inflation concerns and diverging expectations for central-bank policy is likely to keep financial markets highly sensitive to every word from policymakers this week.