Optimism starts to fade but US dollar broadly stable for now

USD: Uncertainty over negotiations hits confidence

Asian equities are mainly lower today with the Euro Stoxx and S&P futures both lower on the day as well as investors begin to doubt the potential for a near-term de-escalation given the conflicting information on negotiations between the US and Iran on implementing a ceasefire. The 15-point plan from the US and the 5-point response from Iran would certainly suggest the prospect of agreeing to a ceasefire are not particularly good. Of course public rhetoric from Iran could mask a greater willingness to de-escalate but equally there is some logic in Iran holding off from agreeing a ceasefire to commence negotiations at a later date when it may feel it would have more leverage with US political appetite for the conflict at a later date likely less than it is now. Still, crude oil prices are only up modestly today – around 3% - and we will likely need to see much more substantial gains in order for broader risk aversion to pick up.

For now the focus is more on the inflation consequences rather than economic growth specifically and that has helped contain the drawdown in equities. The S&P 500 is now down just 4.2% since the conflict began. Declines are larger elsewhere where there’s a negative terms of trade shock coming. Energy-import heavy countries are starting to report evidence of shortages, possibly at this stage as much through panic buying than anything else but that could spread and cause economic disruption quickly. There were reports from Bloomberg of fuel shortages in hundreds of retail outlets in Australia (imports most of its refined fuel) while today there are reports in Asia media (channelnewsasia.com) of shortages emerging in Laos. Bangladesh and Sri Lanka have implemented fuel rationing measures. As more countries curtail their own energy exports this can spread further. We don’t necessarily need to see the conflict worsen but the longer it drags on the more the supply crunch is set to disrupt economic activity.

Closer to home, here in the UK, we are seeing the impact on the consumer. A new BRC measure of consumer confidence revealed its three months ahead expectations index plunged from -30 to -53 in March – the worst reading although the series only began in March 2024. It still is indicative of the shock coming. Higher inflation, weaker growth and higher mortgage costs will likely see consumers retrench and prepare for the worst. Fuel Finder UK indicates a 13% increase in petrol prices over the last 30 days highlighting another hit to real incomes that is already under way.

A deterioration in growth expectations by investors remains modest based on the performance of equities but if/when that intensifies the broader risk-off will likely see the US dollar advance further initially with high-beta G10 underperforming as terms of trade and yield as a driver of FX fades. The risk of this materialising is certainly rising but for now hope of a ceasefire remains the key anchor for financial market risk.

USD CORRELATION WITH VIX IS STRONGLY POSITIVE

Source: Bloomberg, Macrobond & MUFG GMR

EUR: ECB makes clear its reaction function

There has been a lot of focus on whether the rates move we have seen since the start of the conflict in the Middle East are realistic given an energy price shock would be growth negative. However, as we suspected, the central bank responses to an energy price shock is likely to be quite different to before. In the past there has been a tendency to focus on downside growth risks rather than upside inflation risks.

Yesterday, the ECB held its annual “ECB & Its Watchers” conference in Frankfurt with both President Lagarde and Chief Economist Philip Lane speaking. Our sense from the speeches was that the ECB has a much stronger resolve to tighten the monetary stance than what we have seen in the past. Lagarde spoke ensuring the ECB is not “paralyzed by hesitation” (perhaps a lesson from 2022?) and of a “forceful” response to a larger and more lasting energy price shock. Lane was not as direct and emphasised the data-dependent approach to assessing the risk of an inflation upturn that may require a response. He highlighted some upcoming survey data as important in assessing those inflation risks that suggested if those data were alarming that the ECB could be compelled to hike sooner rather than later. Lagarde stated that the ECB was prepared to act “at any meeting”.

At this juncture, the comments are credible evidence of a likelihood of action, some time in Q2. Equity market performance and broader financial market conditions will be important but if equity markets remain relatively resilient then action is more likely than not. The chart above highlights the difference in yields on this occasion compared to 2022 after Russia’s invasion of Ukraine. The 2-year yield over the ECB policy rate is rising more sharply now than in 2022 despite the ECB policy rate back then being negative.

We would still argue that the fact that the ECB was successful in ultimately achieving price stability (unlike the BoE or Fed) gives the ECB a little more time to assess the risks. However, the comments from Lagarde in particular point to limited tolerance with a possible preference to act pre-emptively and accept the downside risks to growth rather than wait and therefore accept the upside risks to inflation.

The very different rates moves in Europe to this inflation spike compared to the past may be playing a role in curtailing the negative terms of trade shock but if broader risk aversion picks up and global equities fall more sharply on global recession risks, relative yields will have much less impact and we would likely see a more pronounced move stronger for the dollar. For now though, the ECB clearly sees the value in talking tough and waiting for evidence of the inflation impact. That raises the importance of incoming survey data on inflation. If the euro-zone PMI Composite Input Price index is anything to go by, we could be set to see very sharp increases in inflationary gauges. The Input Price index surged 6.94 points in March, the second largest one-month increase on record, only surpassed in March 2022 following Russia’s invasion of Ukraine (+7.04pts).

2YR YIELD SPREAD OVER ECB POLICY RATE RISING MORE SHARPLY NOW THAN IN RUSSIA-UKRAINE ENERGY PRICE SHOCK

Source: Bloomberg & MUFG Research

KEY RELEASES AND EVENTS

Source: Bloomberg & Investing.com