Oil retracement ease upward pressure on US dollar – but will it last?

USD: De-escalation hopes

After nearly hitting USD 120 p/bl Brent crude oil fell below the USD 105-level yesterday on hope that the conflict could de-escalate. In particular, the comments from Benjamin Netanyahu that the conflict could be over “faster than people think” helped improve sentiment. Netanyahu also confirmed that Israel would not attack Iran’s energy production facilities again. But the retaliatory attacks have kept coming from Iran with Saudi Arabia reporting that it had intercepted four drones and two missiles. Bahrain also confirmed an attack while in Kuwait the authorities have shut down parts of a refinery on the coast. President Trump denied that the US was considering ‘boots on the ground’ but Netanyahu also stated when he spoke yesterday that “you can’t do revolutions from the air” and that “there has to be a ground component” and suggested that different kinds of options had been considered.  

So it’s hard to be convinced on the prospect of the retracement in crude oil prices lasting and it probably wouldn’t take much to see investor concerns escalate and crude to take another lurch higher. Brent is drifting higher again today as supply continues to be curtailed. Bloomberg is reporting data from Vortex indicating the rapid decline in crude oil in storage at sea which could soon result in the US formally lifting sanctions on Iranian oil already at sea. US Treasury Secretary Scott Bessent estimated that there were 140mn barrels of Iranian crude at sea and if the conflict drags on the greater the appetite will become for easing restrictions on Iranian oil, just like what has happened with Russian oil. But opening the Strait of Hormuz remains vital for easing global supply concerns.

With the potential for this optimism to fade again quickly we continue to see scope for the dollar to extend gains further. The DXY index has only advanced 1.8% so far since the conflict began which is less than would have been assumed with crude oil prices where they are today. The resilience of equity markets is likely one factor with risk aversion relatively modest since the crisis began – the S&P 500 is down 4.0%. The speed in which key central banks outside of the US have signalled the possibility of hiking rates (see below) has also resulted in short-term spreads moving against the US dollar. With crude oil prices not yet at a level that hits growth expectations severely, yield is continuing to play a supportive role for non-dollar currencies. If growth expectations deteriorate, then yield spreads will become less influential and the dollar would likely then extend gains further. At this juncture higher oil prices from current levels seems more likely than a further retracement lower.

BRENT CRUDE OIL CORRELATION WITH USD HAS STRENGTHENED NOTABLY

Source: Bloomberg, Macrobond & MUFG GMR

EUR & GBP : Ready to act with perhaps less patience from the BoE

We have covered yesterday’s monetary policy announcements from the BoE (here) and the ECB (here) and in terms of financial market reaction it was the BoE announcement that stood out. The BoE’s 9-0 vote was itself a notable shift from the 5-4 MPC decision in February and were it not for the conflict, the MPC would very likely have cut yesterday. But with the two most dovish MPC members – Alan Taylor and Swati Dhingra – voting for no change in rates, the prospect of a more meaningful shift in stance is greater. Dhingra even suggested the potential need for a hike in a more severe scenario. However, our conclusion following the scale of the moves yesterday is that the rates moves look a little overdone. The SONIA 3mth Dec 2026 contract fell nearly 50bps yesterday and the 2-year Gilt yield jumped 31bps. Since the conflict began, the 2-year yield is up nearly 90bps. The 7-year swap rate is up 60bps in the same period and will see further substantial increases in UK mortgage rates over the coming weeks.

Governor Baily, in media comments later yesterday, advised caution “against strong conclusions on future rate hikes” and certainly suggests Governor Bailey too believes the market reaction may have been excessive. He also correctly reminded that conditions today are very different to 2022-23 given rates back then were very low and inflation was pushed higher by pent-up demand related to covid. While we do suspect the rates move is overdone it is also understandable given the scale of short-term uncertainties. However, we maintain that if the situation in the Middle East continues to worsen and energy prices advance further, the resilience of equity markets is likely to change and sharper falls in equities will likely see some of the scale of tightening priced being reversed. The pound is deriving support from the surge in yields (although less support than usual for such a scale of rates move) and that will likely give way if broader risk conditions worsen.

The ECB was in somewhat of a better position given it provided a more detailed communication via a press conference and the quarterly forecasts update in the staff macroeconomic projections which also included different scenarios for crude oil price moves. There was a clear message from President Lagarde – the ECB is in a “good position” to deal with the uncertainties and given the ECB has already achieved its price stability goal, unlike the BoE, there was a sense of less urgency in Lagarde’s comments. Similar to the GBP view, we are not convinced that the jump in front-end yields will continue to support the euro. The DXY correlation with yield spreads has weakened considerably with a correlation with Brent taking over and hence we continue to see EUR/USD downside risks related to the conflict. The yield dynamic may curtail the scale of drop and indeed the yield spread move was quite different in 2022. After Russia’s invasion of Ukraine the EZ-US 2-year swap spread fell about 60bps in the first 2mths. So far that same spread is 15bps higher.

SCALE OF 2YR GILT YIELD INCREASE THE LARGEST SINCE TRUSS EPISODE

Source: Bloomberg & MUFG Research

KEY RELEASES AND EVENTS

Source: Bloomberg & Investing.com