USD hits fresh Middle East conflict highs against other FX majors

USD: Fed Chair Powell dampens Fed rate hike expectations

The US dollar has continued to trade at stronger levels overnight with the dollar index hitting the highest level since May of last year. Renewed upward momentum for the US dollar reflects heightened concerns over the risk of a more prolonged and disruptive energy price shock for the global economy. The WSJ has reported overnight that President Trump has told aides that he’s willing to end the U.S. military campaign against Iran even if the Strait of Hormuz remains largely closed, likely extending Tehran’s grip on the waterway and leaving a complex operation to reopen it for a later date. It has reportedly been assessed that a mission to reopen the Start would push the conflict beyond President Trump’s timeline of four to six weeks. The report goes on to add that President Trump has decided the U.S. should achieve its main goals of destroying Iran’s navy and missile stocks and wind down current hostilities while pressuring Tehran diplomatically to reopen the Strait. If that fails, the U.S. would press allies in Europe and the Gulf to take the lead on reopening the Strait.

The lack of clear plan to reopen the Strait continues to pose upside risks to global energy prices, although as a net energy exporter the U.S. would be less vulnerable to supply shortages. As the WSJ noted around 83-84% of crude oil and natural gas shipped through the Strait in 2024 was bound for Asian markets. The potential for a bigger hit to growth outside of the U.S. continues to encourage a stronger US dollar.

One factor which is not reinforcing US dollar strength like during the last energy price shock in 2022 is the Fed’s willingness to take its time before responding to the energy price shock. Fed Chair Powell stated yesterday that the Fed is inclined to hold rates steady and look through the energy shock triggered by the Middle East conflict. He noted that “energy shocks have tended to come and go pretty quickly” so that “by the time the effects of tightening take effect, the oil price shock is probably long gone”. He emphasized that the Fed’s policy stance is currently in a good place to wait and see how the situation develops.

However, he did caution that the Fed would be watching inflation expectations closely because a prolonged series of supply shocks could lead businesses and households to start expecting higher prices. At that point, the Fed would have little choice but to act to tighten policy. The U.S. 5-year 5-year forward breakeven rate has actually fallen since the Middle East conflict started providing some reassurance. The relatively dovish comments from Fed Chair Powell triggered a correction lower for US yields. The 2-year US Treasury yield has fallen by around 20bps from its recent high at just above 4.00%. Market participants have moved to price back in a higher likelihood of the Fed’s next policy move being a rate cut rather than a hike.

In contrast, the European central banks of the BoE and ECB are still expected to deliver multiple rate hikes. Normally hawkish ECB Executive Board member Isabel Schnabel did caution though on Friday that they shouldn’t rush to respond to energy price shock and must be careful not to “overreact”. Her comments push back against market expectations for an ECB rate hike as soon as next month. If monetary policies do diverge between the Fed and other major central banks in the coming months it could help to dampen US dollar strength.

USD IS DIVERGING FROM YIELD SPREADS DUE TO ENERGY SHOCK

Source: Bloomberg, Macrobond & MUFG GMR

JPY: Softer Tokyo CPI report is unlikely to discourage BoJ hike

The yen has held on to yesterday’s gains with USD/JPY hitting a low of 159.49 overnight after dropping back below the 160.00-level. Japanese policymakers have pushed back strongly against the upward momentum for USD/JPY at the start of this week. Japanese Finance Minister Katayama warned overnight that they will do their utmost to respond to currency movements on all fronts given the impact on people’s lives and the economy. Finance Minister Katayama told reporters that she has long been mentioning the possibility of “bold action” while noting that FX markets and crude oil futures markets have been extremely speculative. However, she refrained to comment on recent media reports on potential intervention in the oil futures market. The comments continue to signal that there is a high risk that Japan could intervene to support the yen if it weakens further in response to the energy price shock.          

Higher energy prices and the weaker yen are increasing upside risks for inflation in Japan and putting more pressure on the BoJ to tighten policy. The release of the softer than expected Tokyo CPI report for February is likely to provide only short-term relief. The report revealed that headline and core (excluding fresh food) inflation both slowed to 1.4% and 1.7% in February. Base effects from rice and other food items pulled down both measures of inflation in February. The data is consistent with the BoJ’s view of a temporary early year slowdown for inflation. The report does not change our forecast for the BoJ to hike rates further as soon as next month. The BoJ would have to become much more concerned over the negative growth impact from the energy shock to leave rates on hold for longer. Please see our latest FX Weekly for more details (click here). 

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Source: Bloomberg & Investing.com