USD rebounds as optimism over Middle East conflict de-escalation fades

USD: Trump speech triggers return to risk-off trading & stronger US dollar

The US dollar has rebounded overnight resulting in the dollar index rising back above the 100.00-level after hitting a low yesterday of 99.298. FX market volatility has been mainly driven in recent days by comments from President Trump. Investors’ hopes for a de-escalation of the conflict suffered a setback overnight when President Trump told the American public that the US would hit Iran “extremely hard in the coming weeks and threatened to bomb Iran “back to the Stone Ages”. However, he did claim that the core US strategic military operations are nearing completion and they are going to finish the job very fast. While the speech offered few specifics about military objectives or an exit plan, the comments appear consistent with his recent indication that he  could bring an end to the conflict in the next two to three weeks with or without a ceasefire deal with Iran to re-open the Strait of Hormuz. On that front, repeated his warning to other countries affected by the Strait of Hormuz blockage to “protect the Strait themselves” or “buy oil from the U.S.”.

The speech has triggered renewed investor concerns that the Middle East conflict could escalate further before it de-escalates potentially creating more disruption for energy supplies and the global economy. The price of Brent has risen back above USD108/barrel overnight after hitting a low yesterday of USD98.35/barrel. In the FX market, the worst performing G10 currencies  have been the high beta currencies of the Australian and New Zealand dollars, and the Swedish krona amidst a return to more risk-off trading conditions.

The apparent willingness of the President Trump to walk away from the Middle East conflict without re-opening the Strait of Hormuz is putting more pressure on other countries to step in. It was reported yesterday that the UK will this week host talks between 35 countries aimed at forming a coalition to reopen the Strait. Other countries including France, the Netherlands and Gulf states have been involved in private discussions over what naval assets hey would be willing to provide. UK Prime Minister Keir Starmer said the meeting of foreign ministers would discuss ways to “make the Strait accessible and safe after the fighting has stopped”. The proposal is intended to be deployed after a ceasefire in the US-Israeli war against Iran, but tis being fast tracked in reopen to President Trump’s threats. However, Prime Minister Stamer did caution that “I don’t think you can necessarily assume that a de-escalation of the conflict would necessarily at the same time bring the safe re-opening of the Strait”. Until there is a clear plan to re-open the Strait and ease unprecedented energy supply restrictions, we remain concerned that the energy price shock will get worse before it gets better. To better reflect the risk of amore prolonged period of higher energy prices, we adjusted our forecast for the US dollar higher over the next 12 months in our latest monthly FX Outlook report released yesterday (click here).

G10 FX VOLATLITY HAS PICKED UP BUT STILL RELATIVELY LOW

Source: Bloomberg, Macrobond & MUFG GMR

USD: Why is the US dollar not even stronger in response to energy shock?

The US dollar has strengthened in response to the energy price shock triggered by the Middle East conflict but has noticeably lost upward momentum in recent weeks. The failure of the US dollar to extend its advance could reflect a number of factors. Firstly, it could reflect lingering investor optimism that the Middle East conflict and will end soon and is quickly followed by the re-opening of the Strait of Hormuz. That would be the best case for the global economy helping to curtail the scale of the energy price shock. Recent Trump comments over a potential end to US military operations in two to three weeks play into this view but with lack a clear plan to re-open the Strait.

Secondly, US dollar strength could have been dampened recently by the pricing in of a higher US policy risk premium to reflect fresh uncertainty triggered by the Middle East conflict although it is difficult to quantity. Market participants had already moved to price in a higher US policy risk premium earlier this year which had been weighing on the performance of the US dollar and US assets. In US dollar terms, major US equities have still fallen more year to date than European equities although the underperformance gap has narrowed significantly since the Middle East conflict began.

Thirdly, the short-term yield spreads have been moving sharply against the US dollar over the past month. The European central banks of the BoE and ECB have provided more hawkish signals that they are preparing to raise rates in response to the energy price shock while the Fed is happy to leave rates on hold and take it’s time to assess the impact on inflation and employment. The Fed’s current stance was displayed by St Louis Fed President Musalem yesterday who stated “I expect the current setting of the policy rate will remain appropriate for some time”. He could support raising rates if inflation expectations become unanchored, or on the other hand cutting rates if the labour market deteriorates. US rate market pricing is also currently sat on the fence over whether the next policy move will be a cut or a hike.           

KEY RELEASES AND EVENTS

Source: Bloomberg & Investing.com