At the time of writing in mid-day in London, crude oil remained 8% higher on Middle East tensions, while Germany’s DAX (-2.2%) and EUR/USD (-1%) were both trading sharply lower. Currencies and stock markets of oil-importing regions were facing the most pressure. The near-term EUR/USD outlook remains negative for now.
Risk appetite turns sour
The FX reaction to the weekend’s attacks on Iran and Tehran’s response has helped to support dollar, with the euro, yen and other currencies where the economy is reliant on oil and gas imports feeling the heat. With renewed attacks taking place today, investors are in no mood to seek risk, particularly with natural gas prices surging – a clear headwind for the euro. For now, the greenback looks set to remain supported before the focus turns to data later on in the week.
Conflict could last for weeks: What does it mean for the markets?
Donald Trump has warned that the bombing campaign against Iran could drag on for weeks, doubling down on his demand that the country’s leadership surrender. Tehran, however, is showing no sign of backing down, with the nation’s security chief flatly rejecting the idea of negotiations. Instead, Iran appears to have gone into the offensives with explosions reportedly heard across Bahrain, the UEA and Qatar, as Gulf states moved to intercept missiles fired in retaliation.
The FX backdrop has turned distinctly dollar-positive today because of two major reasons: energy prices surging and haven demand rising as energy markets and global equities drop. The US remains largely energy independent, while Europe and much of Asia are not. If tensions in the Middle East persist – and it certainly feels premature to price in de-escalation right now – elevated oil and gas prices will increasingly weigh on energy-importing economies. I think if crude oil were to go above $100 per barrel and hold there for a few weeks at least then that could significantly weigh on the euro and yen in favour of the dollar.
But a sustained period of dollar strength is difficult to foresee only three days into the conflict. Still, any downside for the greenback is likely to remain small until markets gain clarity on how and when this conflict might resolve.
The rise in oil prices is also raising some doubts about the Federal Reserve’s ability or willingness to deliver those previously expected two rate cuts this year. This energy shock arrives just as the January FOMC signalled growing impatience over sticky inflation, with many officials needing to see inflation resume in a convincing downward path, otherwise a stabilising labour market may not justify easing at all.
EUR/USD outlook dented on energy reality check
Unless we see swift de-escalation, the EUR/USD outlook will remain downbeat for a while. Higher energy prices, if sustained, will inevitably force a rethink of the health of the eurozone economy. Investors have been overweight eurozone assets this year on the recovery theme – a theme that becomes harder to sustain if energy costs remain elevated.
Absent any rapid de-escalation, the EUR/USD could easily slip back towards the 1.1650 support area, with scope for a deeper move towards 1.1575, testing the January lows, if momentum builds. Key resistance is now seen around 1.1750 and then 1.1800. Bullish if we go above the latter.
Macro data takes a back seat
For now, macro data may take a back seat to Middle East headlines. That said, US ISM manufacturing is on the docket, with particular focus on the prices paid component given the renewed inflation sensitivity.
In short, the balance of risks in FX has shifted. For now, energy remains the dominant driver – and that keeps the dollar in the driving seat. While the dollar’s safe haven credentials have been questioned at times this year, this particular shock – energy-driven and inflationary – arguably plays more to the US advantage than Europe’s.
-- Written by Fawad Razaqzada, Market Analyst
Follow Fawad on Twitter @Trader_F_R
