MUFG: The USD - FJElite
Yesterday, while US and UK markets were closed, news of a peace deal had helped fuel a notable bout of optimism. Crude oil prices fell over 7% and the US dollar dropped with the Swedish krone and the Australian dollar the top performing G10 currencies as global growth optimism improved. However, strikes by the US in the region overnight has undermined this optimism and created elevated uncertainty. The retracement of moves yesterday fuelled by the optimism have not been fully complete today with US officials still indicating that negotiations are ongoing for a deal to be made. With only a moderate rebound so far today, the drop in crude oil is meaningful - from the start of last week, Brent crude oil is now down nearly 15% underlining the level of optimism now priced for some deal to be reached.
Marco Rubio has played down the US attacks stating that the talks would “take a few days" while President Trump posted that the talks were “proceeding nicely”. US Central Command described the strikes as defensive and had targeted launch sites and boats trying to place mines. The negotiations also appeared stuck on certain aspects like Iran’s ability to control traffic through the Strait of Hormuz and how to deal with Iran's stocks of enriched uranium. These are the issues that have long been the source of disagreement and hence there must be a degree of scepticism over the imminence of a deal being announced. While President Trump has been keen to highlight the progress and an imminent deal, Iran have been actively countering the news of a deal being close. An Iranian spokesperson acknowledged the progress but dismissed the view of a deal being close.
That would suggest, especially after the US strikes, that there is a risk of a further unwind of the move in markets yesterday. The FX moves yesterday were more subdued than the moves in crude oil or in rates - the 2-year German bund yield fell 10bps but EUR/USD had a range of only 30 pips, perhaps reflecting the fact that UK and US markets were closed. The big moves were SEK and AUD and there is certainly scope for a bigger retracement to unfold in those pairs if a deal is not announced soon. EUR/USD could underperform with expectations that we could see a significant escalation in the Russia/Ukraine conflict after reports that Russia has requested the US to evacuate its diplomats from Kyiv ahead of a planned escalation in attacks. The euro performance has lagged trading toward the bottom of the G10 performance table relative to last Friday.
US yields look set to continue to provide support for the dollar with Fed officials more aligned with focusing on inflation risks. Fed Governor Waller’s speech last week underlined the shift with a signal of a potential rate hike if “inflation does not abate soon". We do not believe a rate hike is coming this year and indeed if a credible peace deal is achieved a rate cut this year is still feasible. But until both sides formally announce a deal, investors will likely trade cautiously given the inflationary pressures that are building.
