USD consolidating at weaker levels amidst ceasefire uncertainty

USD: Ceasefire uncertainty a headwind for further high beta FX gains

The US dollar has continued to trade at weaker levels overnight in response to building investor optimism that the Middle East will deescalate further. After threatening to break out of the top of the 96.000 to 100.00 trading range over the past month, the dollar index has dropped back towards the middle of the range this week after the two-week ceasefire was agreed. It remains to be seen whether the fragile truce will hold and lead to a longer-term peace plan in the coming weeks, but the lingering uncertainty has not prevented investors from rebuilding risk asset positions this week. MSCI’s global equity index has risen sharply by almost 8% from the low at the end of last month, and now stands only around 2.5% below the record high level recorded prior to the start of the Middle East conflict in late February. In the foreign exchange market, the main beneficiaries this week from the deescalation of risks related to the Middle east conflict have been the G10 commodity currencies of the Norwegian krone, New Zealand dollar, and Australian dollar alongside the other Scandi currency of the Swedish krona. In particular, it marks a sharp reversal of performance for the New Zealand dollar and Swedish krona that had been the worst performing G10 currencies since the Middle East conflict started. The Australian dollar and Norwegian krone had also underperformed but to a lesser extent.    

Investor optimism that the worst phase of the Middle East conflict has now passed was encouraged further yesterday by reports that Israel’s Prime Minister Benjammin Netanyahu has agreed to hold talks with Lebanon although he still vowed to keep fighting Iran-backed Hezbollah in Lebanon. It followed talks yesterday with US President Trump who stated that the Israeli’s were “scaling back” operations in Lebanon. The US State Department is expected to host a meeting with Israel and Lebanon next week to discuss ongoing ceasefire negotiations. Continued fighting in Lebanon has been threatening the fragile ceasefire agreement with Iran who warned that they could withdraw from the agreement if Israel keeps up its Lebanon campaign. Iran wants the fighting in Lebanon to stop as part of the ceasefire agreement with the US and could be one reason why there has been little progress so far in re-opening the Strait of Hormuz. The lack of progress prompted President Trump to warn Iran yesterday that it is failing to honour the ceasefire by not fully re-opening the Strait while demanding unrestricted and toll-free shipping. US and Iranian delegations are set to meet in Pakistan tomorrow. The latest developments highlight that the path to a longer-term peace deal still faces significant hurdles, and it is not yet clear how quickly energy supplies through the Strait of Hormuz will resume. The lingering uncertainty could dampen further near-term gains for high beta currencies.  

THE USD HAS QUICKLY GIVEN BACK INITIAL ENERGY PRICE GAINS

Source: Bloomberg, Macrobond & MUFG GMR

USD: Fed response to energy price shock in focus ahead of US CPI report

The main macroeconomic development today will be the release of the latest US CPI report for March. It will provide evidence of the initial impact on inflation from higher energy prices triggered by the Middle East conflict. According to Bloomberg, the consensus forecast is for headline inflation to jump to 3.4% in March up sharply from 2.4% in February. The average price of gasoline has increased by almost 40% since Middle East conflict started in late February. With the jump in headline inflation on the back of higher energy prices well anticipated, market participants will likely focus more on inflation pressures elsewhere by looking at the core measure of inflation. The consensus forecast for core inflation is for a smaller increase to 2.7% in March up from 2.5% in February. It is still likely too soon to assess evidence of any second-round/spill-over effects from higher energy prices to underlying inflation pressures.

New York Fed President Williams stated earlier this week that his outlook for underlying inflation pressures was largely unchanged. He expects core inflation to rise by just one or two tenths of a percentage point in response to the energy price shock. As a result, he believes that monetary policy is “really well positioned” which allows them to respond if the situation changes. At the same time, he expressed more confidence that Us labour market is “more stable now”. Overall, the comments fit with the US rate market’s view that the Fed is likely to keep rates on hold for longer this year, and still lean more toward the next policy move being a cut rather than a hike.

The Fed’s reluctance to tighten policy in response to the energy price shock has helped to dampen US dollar strength since the Middle East conflict began. The dollar index currently stands only around 1.4% stronger than late February even though the price of oil has increased more significantly by around 35%. The relative underperformance of the US dollar during the current energy price shock supports our decision to maintain a bearish forecast profile in our latest monthly FX Outlook report (click here). A heightened US policy risk premium could also be playing a role in dampening US dollar strength like we saw earlier this year before the Middle East conflict began.  

KEY RELEASES AND EVENTS

Source: Bloomberg & Investing.com