Trump extension prompts only modest rebound in risk

USD: Investors appear sceptical of US-Iran talks

The price of Brent crude oil dropped sharply after the announcement yesterday by President Trump that he was extending the pause in attacks on Iran’s energy assets until 8pm EST on 6^th April but the drop has by now fully retraced underlining a level of scepticism amongst investors over the prospect of a successful outcome. The US dollar weakness in response to the announcement has also been fleeting with the DXY now around 0.1% weaker from when the announcement was made. According to Iranian state media, Iran is awaiting a response from the US after rejecting its 15-point plan with its own demands including a guarantee of no further strikes by Israel and the US, full rights over the Strait of Hormuz, the payment of war reparations and the end of all hostilities in the region (Israel’s conflict with Hezbollah in Lebanon). Based on these demands and the US 15-ppint plan, the prospect of an agreement look slim.

Given the pause until 6^th April only includes attacks on energy assets, the conflict looks set to extend further and the longer the Strait of Hormuz remains closed the greater the energy supply problem will become. There was some gesture from Iran by letting ten tankers through but given the Strait of Hormuz is a key part of Iran’s leverage there seems little prospect of a more meaningful flow of traffic being allowed through any time soon. So crude oil prices look set to continue drifting higher which raises the prospect of a bigger episode of risk-off as global recession risks rise.

The inflationary consequences and the scepticism over the prospect of a near-term peace deal prompted big moves in the JGB market today. The 30-year JGB yield jumped 18bps to close just above the 3.70% level, the biggest one-day move since January when fiscal risks were elevated. The latest JSDA JGB flow data for February revealed still very strong demand for super-long JGBs by foreign investors with purchases totalling JPY 1,061bn. In the 12mth period to February foreign investors bought a huge JPY 15trn worth.

Can Japan depend on that demand in current circumstances? There must be a high risk of diminished risk appetite given the uncertainties associated with the Middle East conflict. Higher energy-related inflation, the potential for further fiscal slippage to provide households with cost of living support, and the risk of a sudden sharp bout of yen depreciation on a break of 160.00 in USD/JPY all add to JGB selling pressure. Finance Minister Katayama today certainly upped the rhetoric on intervention but words are losing value. How quickly intervention takes place above the 160-level is also unclear and given the fundamental backdrop, the MoF may allow a more extended move than is currently assumed. We would still expect intervention though and don’t rule out US involvement either. It’s a risk (rather than a core view) given the Fed checked rates in USD/JPY in January and Washington generally is unhappy with dollar appreciation.

FOREIGN INVESTOR DEMAND FOR SUPER-LONG JGBS STILL VERY STRONG

Source: Bloomberg, Macrobond & MUFG GMR

USD: Safe-haven status & GBP downside risks, CHF upside risks

As we approach the weekend – the fifth weekend of the conflict – the financial markets remain incredibly resilient and unrealistically optimistic. As outlined above, the path to de-escalation looks more challenging and Iran’s public rejection of a push for negotiation and peace leaves us potentially on the cusp of  more pronounced episode of risk-off as higher crude oil prices raises more serious fears over the outlook for global growth. It’s remarkable that the VIX index has moved just 7.5pts from the 20-level prior to the conflict starting.

If we are about to enter a more pronounced period of risk-off with larger equity market falls we would expect the US dollar to extend stronger. In January we saw doubts emerge over the dollar’s safe-haven status and dollar debasement fears saw gold and silver surge. President Trump described the selling of the US dollar in January as “great”. We certainly continue to believe the fundamental backdrop for the dollar remains poor and we continue to expect renewed dollar depreciation beyond this period of conflict in the Middle East. But we do not expect that to be on show over the short-term and fully expect the dollar to benefit most if the equity markets take a bigger hit. In a scenario of more intense risk aversion we doubt terms of trade and yield dynamics will play much role in FX direction. In a more severe scenario of Brent crude oil trading in a range of USD 120-160pbl (Our severe scenario as outlined in a recent FX Weekly) and equity markets taking a bigger hit, the DXY could advance closer to the 105-level (+7%-8% from pre-conflict level).

However, the composition of performance within G10 would likely change as well. This is already starting to become evident in FX performance. Australia is the second largest exporter of LNG in the world and since the conflict began through to Monday AUD was the 4^th best performing G10 currency (after USD, GBP and CAD), helped by a positive terms of trade and a hawkish RBA. Now AUD has dropped to 7^th with just CHF, NZD and SEK performing worse.

The performance at the very top of the table could change as well. The history of GBP performance in periods of risk aversion is not good and added to that yield can turn from a positive to a negative as investors turn their focus to growth. The scale of increase in yield in the UK has been huge – the OIS pricing for year-end has swung from investors expecting two cuts before the conflict to now expecting three hikes. The speed of the rise in the 2-year Gilt yield, as can be seen in the chart, has only been surpassed once – during the Liz Truss sell-off in 2022. Real GDP in the UK pretty much stagnated in 2023 in part on the tightening financial conditions in late 2022.

So GBP being the top performing G10 currency after the US dollar doesn’t make much sense to us and if we are about to see an escalation in risk-off trading we’d expect to see GBP underperform, potentially notably. CHF on the other hand, which is underperforming given the relative resilience of risk assets, would likely start to outperform more clearly.  

SCALE OF 2YR GILT YIELD INCREASE HIT 1.0PPT THIS WEEK – THE LARGEST INCREASE IN THAT PERIOD (15 DAYS) SINCE TRUSS EPISODE IN 2022

Source: Bloomberg & MUFG Research

KEY RELEASES AND EVENTS

Source: Bloomberg & Investing.com