Middle East conflict triggers stronger USD

USD: Middle East conflict to trigger bigger rebound?

The US dollar has strengthened sharply at the start of this week triggered by the military conflict in the Middle East over the weekend. The dollar index has climbed back above the 98.000-level as it moves further above the low from late January at 95.551. The Norwegian krone and Swiss franc have outperformed alongside the US dollar supported by the combination of the higher price of oil and pick-up in safe haven demand. The price of Brent initially jumped to a high of USD82.37 overnight but has since dropped back below USD80/barrel in response to heightened fears over the potential disruption to global oil supply. According to Bloomberg, tanker traffic though the Strait of Hormuz has largely halted, with a self-imposed pause in place by shipowners and traders as the conflict spreads within the Middle East. Iran stated on Sunday that the strait remains open, but it also said it attacked three oil tankers over  the course of the day. The Strait of Hormuz is an important choke point for the global economy given that about a fifth of the world’s oil and liquefied natural gas typically flows through every day. For now takers are continuing to pile up outside the waterway as companies wait for clarity on the security situation. According to Bloomberg, two insurers have privately stated that they expect to significantly hike fees they charge for calling in the Persian Gulf.            

Market participants are likely to continue to price in a geopolitical risk premium into the price of oil for the foreseeable future. As we have highlighted previously, a bigger and more sustained oil price spike poses upside risks to our outlook for a weaker US dollar. Asian and European economies will be hit harder by the negative terms of trade shock from higher energy prices than the US economy, and higher energy prices are likely to curtail room for the Fed to lower rates further this year. These positive factors should offset the drag from heightened US policy uncertainty. Our forecast for a weaker US dollar was built on the assumption  that the Fed would lower rates by another 50-75bps this year but that will be more difficult to justify if inflation remains higher for longer in the US. The last time there was a significant energy price shock was following the start of the Ukraine conflict in early 2022, and on that occasion the dollar index strengthened sharply by almost 20% between February 2022 and September 2022. While we are not expecting a similar sized move higher for the US dollar this time around, it does provide a clear example of the upside potential for the US dollar. In contrast, the last US military strikes in Iran in June 2025 had more limited impact on the US dollar and proved to be short-lived. On that occasion the strikes were much less disruptive.            

On this occasion though there is a higher risk that the military conflict in the Middle East proves more disruptive and lasts longer resulting in a bigger market impact. President Trump told the New York times that the military operation could last four weeks or five weeks, while indicating that he is open to talks with Iran to bring an earlier end to the conflict. He told Fox News that 48 of Iran’s top leaders have already been killed including Ayatollah Ali Khamenei which is likely to make it more challenging to reach an immediate diplomatic solution. There is currently an interim leadership council in place which includes President Masoud Pezeshkian, judiciary chief Gholam-Hossein Mohseni-Ejei, and senior cleric Alireza Arafi who will appoint a new leader.  

According to press reports, Iran has retaliated by targeting US military bases in Bahrain, Iraq, Kuwait, the UAE, Saudi Arabi and Qatar. The developments have increased the risk of a broader regional conflict in the Middle East. Israel has already attacked Hezbollah targets in Lebanon. President Trump’s desire for regime change in Iran has created more uncertainty. So far there is little evidence that people in Iran are rising up to overthrow the current regime who are more likely to hit back hard against usurpers as they seek to remain in power. It could lead to more unpredictable and disruptive attacks triggering volatile financial market conditions. President Trump will need to dampen the energy price fallout for US consumers ahead of the mid-term elections later this year. His popularity has already suffered from the cost of living crisis at home which is likely to be made worse by the conflict in the Middle East.

ENERGY PRICE SHOCK TO ENCOURAGE STRONGER USD

Source: Bloomberg, Macrobond & MUFG GMR

KEY RELEASES AND EVENTS

Source: Bloomberg & Investing.com