The Geopolitical Tensions and Their Impact on Currency Markets
In the world of foreign exchange, the escalating tensions between the US and Iran have become a dominant force, overshadowing other market drivers. The dollar, often seen as a safe haven, has responded to this crisis, but its reaction has been somewhat muted, leaving room for further movement.
Dollar's Response: A Cautious Approach
The US dollar's appeal as a safe haven has historically been influenced by geopolitical tensions and oil prices. While its safe-haven status may be diminished in post-Liberation Day markets, it quickly regains its position during times of heightened geopolitical risk. This is particularly evident when alternative safe-haven currencies like the Euro and Japanese Yen, heavily reliant on energy imports, become less attractive due to surging crude prices.
Oil prices have been closely tied to the perceived likelihood of a US strike on Iran, as indicated by Polymarket's implied probability. As this probability has climbed to 60%, oil prices have followed suit, reaching the $71-72 range seen in late January. If this relationship holds, a 100% probability could push oil prices even higher, potentially to $75-76.
The key question is whether Iran will block the Strait of Hormuz, an action that would significantly impact global oil supplies. Currently, this risk is only partially priced into the market, with Polymarket estimating a 18% probability by the end of March and 35% by the end of the year.
Dollar's Reaction: A Balanced Perspective
The dollar's response has been noticeable but not excessive, especially considering its undervalued position relative to short-term fundamentals. This could be attributed to market reluctance to fully price in geopolitical risks, given the rapid de-escalations witnessed over the past year. However, the current military build-up in the Middle East is the largest since 2003, suggesting that this may not be a simple show of force ahead of US-Iran negotiations.
US President Donald Trump has hinted at a 10-15 day timeframe to agree on a nuclear deal, but reports suggest a limited early strike is also a possibility. Markets may need to see more encouraging headlines on diplomatic efforts and a reduction in military threats before selling the dollar in this environment. Today, it might be too soon for such developments, leaving USD with upside risks.
Data Release and Macro Impacts
Today, the US will release some crucial data, including the Fed's preferred core PCE inflation for December and fourth-quarter GDP. While we expect these figures to align with consensus estimates, there is a risk of a hotter print for inflation. For GDP, we anticipate a quarterly annualized growth of 2.7%, closely matching the consensus of 2.8%.
If there are no new developments regarding Iran today, data surprises could influence the market. However, even without new macro inputs, the dollar still has significant room to rally if oil prices continue to surge.
Euro: Overvalued and Vulnerable
The euro finds itself in a challenging position when oil prices rise. While the associated risk-off in equities and the euro's recent status as a safe-haven alternative to the dollar help mitigate losses, the currency pair's reduced sensitivity to oil in the past year makes it difficult to estimate the impact of further oil rallies.
Our current model, which considers 12-month rolling betas, suggests that another $5 rally in Brent could lead to a 1% decline in EUR/USD. However, during oil shocks, this correlation often strengthens, indicating the potential for an even larger selloff in the pair.
EUR/USD is currently trading around 1% above its short-term fair value, calculated excluding oil prices. This, in our view, confirms the market's reluctance to fully price in geopolitical risks. As a result, we believe EUR/USD faces significant downside risks and could trade down to 1.160 in a major escalation.
Macro Insights: Eurozone PMIs
Today, we will see the release of eurozone PMIs. The disappointing ZEW index earlier this week may temper some enthusiasm for today's surveys, but the eurozone composite PMI is expected to remain well above the 50.0 expansion/contraction threshold, allowing for mild optimism. The impact on the euro is expected to be limited.
GBP: Weighing on the Margins
We continue to see short-term upside potential for EUR/GBP. The current fragility in risk sentiment due to geopolitical risks is likely to impact GBP more significantly than EUR. However, it is primarily domestic dynamics that will continue to weigh on the pound, in our assessment.
We anticipate a rate cut at the Bank of England's March meeting, which is now priced in at 20bp, and we forecast another move in June, which is only 40% priced in. Political risk remains a major concern for the pound.
Our baseline for EUR/GBP remains a move past 0.880.
CAD: A Stable Performer
The loonie is expected to perform well in the crosses in the current environment. Its lower volatility in the commodity FX space, specific sensitivity to oil prices, and stricter correlation with USD make it an attractive alternative. While we retain concerns about upcoming USMCA renegotiations, CAD is the only G10 currency that is not overvalued in our short-term model versus USD. The slightly sub-consensus Canadian CPI print earlier this week is not expected to trigger major dovish shifts at the Bank of Canada just yet.
Conclusion: Navigating the Currency Landscape
As the US-Iran tensions escalate, the currency markets are in a state of flux. The dollar's response, while visible, leaves room for further movement, especially if oil prices continue to rally. The euro, vulnerable to oil price surges, faces significant downside risks, while the GBP and CAD are influenced by domestic dynamics and geopolitical tensions.
And here's where it gets controversial...
Do you think the market is underestimating the impact of geopolitical risks? Are we headed towards a major escalation that could significantly impact currency pairs? Share your thoughts and predictions in the comments below!
