Optimism surges but questions remain unanswered

USD: Risk-on weakens the dollar but move will likely be limited

The price of the front active Brent crude oil contract has declined from the peak hit in Asian trading yesterday with optimism elevated that the US about to call an end to the conflict with Iran. The S&P closed nearly 3% higher and has fed through to the Asian region with strong gains reported following indications from President Trump that the US would withdraw “within two weeks, maybe two weeks, maybe three”. Trump added that a deal with Iran was possible but not necessary for the conflict to end and claimed that regime change had been achieved and that the main goal of removing the nuclear threat of Iran had also been achieved. Karoline Leavitt also confirmed that President Trump will address the nation tonight at 9pm EST without providing any details.

There is certainly a logic to this rebound in risk on renewed optimism but there are numerous questions that remain unanswered over how this conflict will evolve over the coming weeks. Firstly, could this be part of a big ruse for an actual escalation in the conflict by the US? Sounds unlikely but who really knows with President Trump. Secondly, the conflict will continue for two to three weeks – that’s a considerable period of time in which developments could easily change the intention of the US to de-escalate so we can’t take this commitment wholeheartedly just yet. Finally, and perhaps most importantly, what about the Strait of Hormuz? As the WSJ reported yesterday, it looks like the US is going to leave and hope that the exit of the US will encourage Iran to reopen the key chokepoint for global energy. That could prove correct but it is no certainty that Iran will play it like that.

The US is just one player in this conflict. There is reportedly a growing conviction in the Middle East – in particular in Saudi Arabia and the UAE – that the Iranian regime should not remain in place. Israel’s war in Lebanon looks likely to continue which could well be reason for Iran not to de-escalate as quickly or as easily as perhaps the US currently assumes. If this conflict ends in the way being suggested it will only embolden the Iranian regime which will inevitably claim victory.

So, the recovery in risk is likely to remain fragile with doubts set to return over the improvement in energy supply conditions. What we would say though in relation to FX is that the US dollar will look even more vulnerable following this conflict (again if it ends like being suggested). The decision to attack Iran will leave the region extremely unstable and inflation risks will likely continue to undermine the Trump administration ahead of the mid-terms in November. Data above shows the largest reduction in custody holdings of UST bonds held by foreign central banks at the Federal Reserve since covid in 2020 and prior to that since 2014. Fiscal risks are set to worsen and the whole topic of confidence in US assets is likely to re-emerge in the period following an end to this conflict that likely means a quick reversal of recent US dollar strength and the resumption of the trend of US dollar depreciation – consistent with the forecasts we published in March and in our updated FX Outlook report to be published today.

4-WEEK CHANGE IN FED’S FOREIGN CB HOLDINGS OF UST DOWN SHARPLY

Source: Bloomberg, Macrobond & MUFG GMR

GBP & JPY: Top performing G10 after the US dollar

As stated above, the US dollar was the top performing G10 currency in March following the surge in energy prices due to the conflict in the Middle East. But the next best performing were the yen and then the pound. Close behind were the currencies you’d have expected to be at the top of the performance table – the Norwegian krone and the Canadian dollar. We would argue that the yen has the better prospects of sustaining this performance than the UK pound going forward from here.

Firstly, the terms of trade shock in 2022 for Japan was huge (the 12mth rolling sum of the energy trade deficit went from JPY 10trn to JPY 33trn over a 2-year period from March 2021) but that is unlikely to be repeated this time. The natural gas price shock in 2022 was far bigger than what has taken place so far and assuming we do not see multi-fold increases in the natural gas price this will certainly limit the expansion of Japan’s energy trade deficit. In addition, the government’s response now to this energy shock is very different. Under the OECD-agreed crude oil reserve release, Japan has announced that it would release 80mn barrels from its Strategic Petroleum Reserve. Of the total OECED release (400mn barrels) Japan’s release is the second largest after the US. The Japanese government is also lowering the private sector mandated minimum stockpile from 70 days’ worth to 55 days’ worth. Combined the drawdown will equate to around 50 days’ worth of consumption. By comparison, Japan released 7.5mn barrels from its SPR in 2022 following the Russian invasion of Ukraine. So the action from Japan on this occasion will likely mean the terms of trade shock will be considerably less than in 2022. While Japan’s refining capacity has declined it remains in the top ten globally.

For the UK, the vulnerability looks greater and hence the pound performance is of greater risk of turnaround. In reality, the pound performance looks more yield-related. The UK’s overall energy import dependency is rising due to the decline in North Sea oil production and has now reached close to 45%. Oil and gas make up about 90% of the UK’s energy imports and refined fuel imports have grown with diesel and jet fuel the main imported refined products. The UK’s refinery capacity has fallen steadily over time from as many as 18 refineries in the early 1980’s to just 4 now.

The price of jet fuel has doubled in the current energy shock while diesel prices are rising faster than petrol prices. According to RAC Fuel Watch, the price of petrol has increased by about 13% while diesel prices are up close to 25%. The CEO of Shell has stated that Europe could experience refined fuel shortages later this month.

With risk aversion potentially set to rise as global growth fears increase and given the vulnerability of the UK to a bigger terms of trade hit and potentially fuel shortages, the pound could be set to reverse its relative resilience seen in March. If this renewed optimism translates to sharp falls in energy (a big if at this stage) the surge on front-end yields will likely reverse and reinforce a potential correction for the pound.

3-DAY % CHANGE IN EUR/GBP THE LARGEST SINCE AUGUST LAST YEAR

Source: Bloomberg, Macrobond & MUFG GMR

KEY RELEASES AND EVENTS

Source: Bloomberg & Investing.com