A week of revamped Middle East tensions has left the dollar broadly unchanged. Oil prices have come back lower, allowing risk sentiment and high-yielding EM FX to rebound. The risk is clearly that markets are too sanguine, but fading has been the successful strategy so far, and markets understandably remain laser-focused on front-end rate differentials
USD: Stuck as Markets Fade Geopolitical Risk
Markets are taking a decisively optimistic stance on fresh US-Iran tensions. Multiple reports indicate traffic in Hormuz has dropped to almost zero in the past couple of days, and we have seen effectively no intent of de-escalation from either party.
The US is reportedly striking Iranian bridges for the first time since April, and Iran is threatening a new full Hormuz blockade. Yet investors are probably clinging on to the fact that technical talks between the two parties are continuing, and has dropped back to $76/bbl after briefly touching $80 on Wednesday, dragging front-end rates lower. The 2-year USD swap rate has erased roughly half of the 10bp jump after the re-escalation – 35bp of tightening is currently priced in for December.
The dollar is seeing no benefits from this situation. Fading geopolitical risk means continuous focus on rate differentials, which have moved against USD in some instances (e.g., vs the euro) by revamping hawkish expectations abroad. Incidentally, the recovery in risk sentiment yesterday prompted a decent rebound in high-yielding EM FX after an unwinding of carry trades earlier this week.
The risks here are obvious. Investors may be underestimating the chance of a new Strait of Hormuz closure and non-linear oil spikes. The balance of risks remains on the upside for the dollar, although only a modest pick-up in oil prices and markets rapidly turning to headline fatigue would probably leave pretty much where it is now. The data calendar is quiet in the US today, and there are no scheduled FOMC speakers.
This morning, the yen rallied to 161.5 after Japanese Finance Minister Satsuki Katayama made a rare appeal for Japan’s pension funds to increase domestic asset holdings. The FX reaction was probably exacerbated by stretched short positioning (35% of open interest, according to the latest CFTC figures), and it seems unlikely to drive a sustainable JPY recovery on its own. With appetite for JPY-funded carry trades intact after Wednesday’s wobble, risks remain on the upside into the next round of intervention for .
EUR: Don’t Downplay Downside Risks
The Middle East military re-escalation has prompted a moderate re-tightening in short-term swap rate differentials. In the two-year tenor (often the best correlated with FX moves), that has been worth roughly 10bp. That spread is still 50bp wider than its April peak, when markets bet heavily on ECB tightening but not on the Fed’s, but only 15bp wider than before the war.
While all this is injecting new confidence into previously dwindling expectations for a September ECB hike, the path for EUR/USD to come out stronger from this re-escalation is quite narrow. We expect stabilisation today – with markets potentially wanting to wait for weekend clarity – but risks are of a retest of 1.140.
CAD: Jobs Data in Focus, BoC to Stay Cautious
Canada releases jobs data for June today. Expectations are for a marked slowdown in hiring to 10k after May’s big 88k, with unemployment staying at 6.6%. The focus will be on permanent employees’ hourly wages, which are expected to increase from 3.2% to 3.6%.
We think the bar for a material hawkish turn by the Bank of Canada is high, and we don’t expect surprises at next week’s meeting. Unless oil rallies back to April-May levels, the inflation outlook remains too benign to hike, especially considering downside risks for jobs and activity related to USMCA uncertainty.
For now, some revamped BoC hawkish bets and some support for oil prices are helping CAD, which is outpacing USD this week. We still think USMCA-related risk premium can be added throughout 3Q and don’t expect a return below 1.40 in the next couple of months.
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