MUFG: The USD - FJElite
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.
