Despite international warnings to prevent an escalation in the Middle East, Israel's war cabinet resolved on Monday to deliver a clear and forceful retaliation, calibrated to avoid sparking a wider conflict.
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Financial markets are on high alert, and the anticipatory movements observed on Friday ahead of the Iranian strike, along with the start-of-week developments following Israel's declaration, have induced pronounced volatility that could persist in the weeks ahead.
US inflation stays hot, ECB sends dovish signals:
Amidst this intense geopolitical turmoil, U.S. inflation has exceeded expectations, registering a 3.5% year-on-year increase in March compared to the forecasted 3.4%, while retail sales figures also surpassed projections (0.7% month-over-month vs. 0.3% expected).
Traders have significantly pushed back their forecasts for the beginning of the Federal Reserve's rate cuts, now seeing September as the most likely date for the first cut and pricing in a total of only 40 basis points of cuts by the end of the year (less than two cuts of 25 basis points each).
In Europe, the ECB has signaled the possibility of a rate decrease in June, contingent on upcoming inflation data remaining favorable. The EUR/USD exchange rate has fallen to 1.0600, aligning with our predictions from last week, influenced by the adverse mix of a heated U.S. CPI and a dovish ECB stance.
In the UK, recent labor market data suggests a softening, as the unemployment rate climbed to 4.2% in February, exceeding the anticipated 4.0%, while wage growth marginally outstripped expectations. Present market anticipations reflect a 60% likelihood of a 25 basis-point reduction at the BoE's August 1st meeting, with an aggregate cut of around 50 basis points anticipated by the close of the year.
All eyes on the Middle East:
During a week light on data, the focus remains squarely on the geopolitical tensions emanating from the Middle East.
Heightened risk of conflict escalation is likely to channel flows towards conventional safe-haven assets, with the dollar and gold poised for a bullish narrative.
Traders should also monitor the concurrent dynamics in oil prices, as Brent continues to trade at $90 a barrel, and with ongoing Middle East disruptions, analysts expect further upside moves.
Consequently, currencies tied to oil, like the Canadian dollar and Norwegian krone, may exhibit resilience, barring major risk-off moves.
Year-to-Date Performance Of Major Currencies: USD Leads, JPY Lags
FX, Gold Latest Reactions To Israel-Iran Crisis
Anticipation of an Iranian attack on Israel was on the radar since late last Thursday, thanks to intelligence efforts, with volatility making a marked return to the markets in Friday's session.
The VIX, known as the "fear index," jumped 15% as investors rushed to hedge risk in the face of a volatility event.
The U.S. Dollar Index (DXY) climbed 0.7% for the session, achieving its highest levels since early November of the previous year. The dollar continued its ascent into Monday, registering an uptick of 0.2%.
The euro and the British pound both saw a depreciation of 0.8% against the dollar, with the euro experiencing its weakest week against the dollar since September of the preceding year. The Swiss franc declined by 0.5% on Friday, touching a seven-month nadir against the dollar. European currencies maintained their bearish momentum as the new week commenced.
The Japanese yen remained stable on Friday, but it started the new week with a 0.6% decline, as robust retail sales figures propelled U.S. Treasury yields and the dollar upwards.
Commodity-linked currencies, such as the Australian and New Zealand dollars, suffered a 1.1% drop on Friday and sustained their descent as the week began.
Gold saw wild swings on Friday, initially soaring to as high as $2,430 per ounce before settling 1.1% lower, influenced by a surge in liquidity moving into Treasuries and the U.S. dollar. However, the precious metal rallied robustly on Monday, achieving a gain of 1.7%.
Chart of The Week: US Dollar Emerges As Major Gainer Amidst Middle East Tensions
Potential FX developments in a Middle East escalation
While each conflict has its own distinct narrative, the closest comparison for understanding the potential repercussions on the foreign exchange markets from intensifying escalations in the Middle East can be drawn from the Russian invasion of Ukraine in February 2022.
On the day of Russia's invasion of Ukraine – Thursday, February 24, 2022 – major currencies experienced marked volatility.
The U.S. Dollar Index (DXY) saw a sharp 1% rise, solidifying its position against all other major currencies.
The British pound, along with the New Zealand and Australian dollars, suffered significant drops, with declines of 1.3%, 1.2%, and 1% respectively. The euro also witnessed a 1% depreciation on that same day, and gold prices dipped by 0.6%.
A week into the conflict, currencies tied to commodities rebounded as primary beneficiaries, propelled by soaring crude oil and general commodity prices. West Texas Intermediate (WTI) crude oil escalated to $110 per barrel, indicating a steep 20% increase in the wake of the Russian offensive within just one week.
The Australian dollar appreciated by 1.3% against the U.S. dollar one week following Russia's incursion into Ukraine, with the Canadian dollar also notching a 0.5% gain. Meanwhile, gold advanced by 1.8%.
Two weeks into the conflict, oil prices were up by 15%, while gold affirmed its status as a principal safe haven, appreciating by 5%. The U.S. Dollar Index (DXY) stood 2.4% higher compared to its position on February 24, 2022.
European currencies along with the Japanese yen bore the brunt of the impact. The British pound shed 3.4%, the euro fell by 2.8%, the Swiss franc by 1.3%, and the yen by 1% from their levels prior to the Russian invasion.
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