US dollar plunges as two-week ceasefire offers optimism

USD: A deal is done but coming weeks will be telling

Brent crude oil is currently 16% lower on the back of an agreed ceasefire between the US-Israel and Iran for a period of two weeks after a 10-point proposal was received by the US and President Trump agreed it was a basis on which to negotiate. President Trump announced the cease fire on Truth Social at 23:30 BST. The Strait of Hormuz will reopen in order to see an improved flow of tanker traffic while negotiations are ongoing. The financial market reaction is as you would expect – equity markets are up notably, US Treasury bond yields are lower and the US dollar has weakened. It’s full-on risk-on for now as you would expect but there are many questions to ponder and there will also be inevitable questions in relation to this deal and whether it has the staying-power necessary to achieve a lasting peaceful settlement that restores investor confidence over the medium to long-term.

Firstly, how credible is the 10-point peace plan and the negotiations that will unfold over the coming two weeks? Who is negotiating on behalf of Iran and does the regime have a unified leadership under which to make a deal? Secondly, how on-board are the other players in the region? At first sight Israel appears to be supportive but PM Netenyahu has confirmed that the deal does not include Lebanon – that points to a possible source of disagreement. If Israel continues to bomb Lebanon will Iran remain at the negotiating table? The Israeli opposition leader has also heavily criticised the deal and has argued that there has never been such a “political disaster in all of our history” as Israel wasn’t even considered in this deal. We have not heard much from Iran’s neighbours in the region either but they too will be concerned over the Iran regime remaining in power after the sustained attacks over the last five weeks. Finally, how quickly will the flow of tanker traffic resume in the Strait of Hormuz? In a Truth Social post President Trump stated that the US would be “helping with the traffic build-up in the Strait of Hormuz” and that “big money will be made” and that the US would be “loading up with supplies of all kinds and just hanging around”. The damage done to production and storage facilities will have a lasting impact and hence tight energy markets will continue for some considerable period of time.

So there are a lot of uncertainties that will persist but having said that, this of course is a step in the right direction and we see this as reducing considerably, over the short-term at least, the risk of a major risk-off and with it a strengthening of the dollar. This outcome is a clear bearish outcome for the US dollar. It’s positive for risk assets, it’s a potential positive for global growth and it will in our view reinforce the monetary policy divergence between the US and Europe. We would also argue that this deal could well bring back doubts over confidence in US assets. The regime staying in power will be portrayed in Iran as victory and investors may question this whole episode from a US strategic perspective and reinforce longer-term doubts in US decision-making.

The US dollar throughout this conflict has underperformed our expectations given the scale of energy price increase and under these circumstances of a ceasefire and possible deal will potentially suffer further losses over the short-term. However, uncertainties are high and hence we would expect markets to remain highly sensitive to incoming news on progress in the negotiations that lie ahead. Reversal trades in G10 on this positive news would imply the big underperformers throughout the conflict could perform best in the coming days – that would point to SEK and NZD performing well at the expense of NOK and GBP – the two top performers since the conflict began.

VIX / USD CORRELATION IS POSITIVE WHICH WILL SEND USD LOWER

Source: Bloomberg, Macrobond & MUFG GMR

GBP: PMIs show bigger downturn in the UK

The pound was the third best performing G10 currency since the conflict began with only the US dollar and the Norwegian krone performing better. The UK has become increasingly dependent on imported fuels and hence is much more exposed than in the past to the energy price surge. The UK economy has also been hit by the surge in yields that may have been a factor providing the pound with support – a ceasefire deal that turns to lasting peace could mean the tightening priced by the markets is fully reversed which would potentially see the pound underperform. We recently instigated a short pound trade view in our FX Weekly publication prior to Easter and while the ceasefire deal changes that, yield could still now play a role (here).

The PMI Service data was released yesterday and the decline recorded was certainly larger than seen in Europe – the final estimate was 0.7ppt below the initial estimate with inflationary risks clearly a key driver in the worsening business sentiment. The PMI Composite Input Price index surged by a record 6.7ppts, surpassing the previous record following the plunge of the pound after the Brexit referendum result in 2016 and hence a larger jump than during the global inflation shock following Russia’s invasion of Ukraine in 2022. With the recent memory of that global inflation shock in the minds of services suppliers, we may well see a faster feed-through in energy-related inflation than what we saw in 2022. Food inflation can also surge quickly on the back of higher energy prices as we saw in 2022. Last week, the UK’s Food & Drink Federation updated its inflation forecasts and now expects a year-end food inflation rate of between 9%-10%. Previously it expected a rate of 3.2%. Those forecasts are based on the assumption of the Strait of Hormuz reopening in the next few weeks and energy production returning to pre-conflict levels within the next year.

That forecast assumption does highlight the potential fallout going forward even under a circumstances of a ceasefire lasting. The forecasts show that the damage has been done to a degree and while a ceasefire is undoubtedly good news, the inflation risks have not fallen away entirely and a rate hike therefore cannot be immediately ruled out. Households will also be hit quickly by rising rates. According to Moneyfacts, 1,780 UK mortgage deals have been removed from the market, over 20% of all mortgages underlining the speed in which higher yields will hit the economy.

The performance of the pound has held up better than expected in part on the back of the surge in short-term yields. Yields will certainly fall sharply in response to this deal but a hit to growth (albeit less than it could have been) is still likely and if crude oil prices and refined fuel prices remain higher than before (likely) there will be a hit to growth and yields will remain higher than before. Some reversal of the pound’s solid performance is still feasible over the coming weeks.  

1-MONTH CHANGE IN PRICES PAID IN UK PMI COMPOSITE A RECORD

Source: Macrobond, Bloomberg & MUFG Research

KEY RELEASES AND EVENTS

Source: Bloomberg & Investing.com