Middle East conflict remains supportive for stronger USD

USD: Fed rate cut expectations continue to be scaled back proving support

The US dollar has continued to trade at stronger levels overnight supported by heightened geopolitical risks in the Middle East. There remains a high level of uncertainty over the potential length of the conflict and scale of disruption to global energy supplies. US Defence Secretary Pete Hegseth added to the uncertainty overnight by telling reporters that the military operations “could be six, it could be eight, it could be three weeks”. Israel’s UN ambassador also added that Iran still has “significant capabilities” and that “there’s still a long way to go”. A prolonged conflict would increase downside risks for the global economy and the risk of a more persistent inflation shock. Our forecasts for US dollar strength to be temporary (click here) are based on the assumption that the conflict last weeks rather months.

At the same time, the US dollar and US yields were lifted yesterday by the release of the latest ISM services survey for February. The survey providence further encouraging evidence that the US economy was gaining upward momentum at the start of this year prior to the outbreak of the conflict in the Middle East and negative energy price shock. The survey revealed that business confidence in the service sector improved to the highest level since July boosted by a 5.5 point jump in the new orders component. The employment sub-component also improved by 1.5 points to 51.8 which was the highest level since February of last year. Market participants are waiting to see if the release of the latest nonfarm payrolls report on Friday provides further confirmation that US employment growth has picked up at the start of this year after the January report revealed private employment growth increased strongly by 172k. The Bloomberg consensus forecast for private employment growth in February is just over 60k indicating scepticism over the sustainability of the pick-up in employment growth.

The recent stronger labour market data and inflation risks from developments in the Middle East have prompted the US rate market to scale back Fed rate cut expectations. There are currently around 42bps of Fed rate cuts priced in by the end of this year compared to around 61bps at the end of last week. If Fed rate cut expectations continue to be pared back it will encourage further US dollar strength in the near-term. While it is still early days to assess the impact of the conflict in the Middle East on the outlook for Fed policy, Fed speakers have so far stated that they have not yet significantly changed their views. Dovish Fed Governor Miran stated he thinks it’s still a appropriate to continue to cutting interest rates given its too early to take a stance on the impact of the conflict on the US economy. A view shared by New York Fed President Williams who emphasized that the oil price effect on inflation depends on the persistence. If higher inflation proves to be more persistent it would be bigger concern as it erode inflation expectations.

One of the reasons that the US dollar strengthened significantly in response to the last energy price shock in 2022 triggered by Russia’s inflation of Ukraine was that the Fed tightened policy aggressively as well. The policy rate rose by 425bps in 2022. With the policy rate now judged to slightly restrictive, there is less immediate pressure on the Fed to tighten policy on this occasion which should help to dampen upside potential for the US dollar in comparison.

USD PERFORMANCE VS. SHORT-TERM YIELD SPREADS

Source: Bloomberg, Macrobond & MUFG GMR

JPY: BoJ still on track to hike rates further subject to Middle East risks

The yen has held up relatively well so far in response to the energy price shock triggered by the conflict in the Middle east. The yen has been the third best performing G10 currency after the US and Canadian dollars since the end of last week. The yen has been supported overnight by a Bloomberg report stating that BoJ officials are still on track to raise interest rates, with the possibility of an April hike not ruled out according to people familiar with the matter. The report supports Japanese rate market pricing which is still discounting around 16bps of hikes by April. The report adds that BoJ officials have not altered their stance of proceeding with rate increases if the economic outlook evolves as expected.

However, the report did indicate that BoJ officials will continue to monitor the implications of developments in the Middle East. Officials view the duration of the conflict as the key variable in assessing the risks to Japan’s economic outlook and the trajectory of interest rates. The BoJ will pay close attention to upside risks stemming from higher oil prices. If crude prices remain elevated amid prolonged tensions in the Middle East, that could push up inflation expectations and reinforce price momentum. It follows comments yesterday from Governor Ueda who expressed concern that Japan’s economy would be hit by higher energy prices. We have been assuming that a more prolonged conflict would make the BoJ become cautious over hiking rates further in the near-term encouraging a weaker yen alongside the negative impact on the yen from the terms of trade shock for Japan’s economy from higher energy prices.             

KEY RELEASES AND EVENTS

Source: Bloomberg & Investing.com