FX Talking: Dollar downturn delayed

Financial markets are once again excited about a potential Middle East peace deal and the possible resumption of energy flows out of the Gulf. Whether that delivers much lower energy prices is highly questionable. What is clear, however, is that the inflation genie is out of the bottle and very few central banks can look through this inflation shock.

The big change over the last eight weeks is that investors now expect the Federal Reserve to tighten policy. This has undermined fears of a ‘captured’ Fed and is powering a cyclical bounce in the dollar. Given a resilient US labour market, above 4% inflation and the risk of higher energy prices, this period of dollar strength can extend into the third quarter. And the much-anticipated dollar decline now looks to be a story for 2027.

In G10, this means that EUR/USD could have a brief window down to 1.13/14 even if the European Central Bank hikes again at either the July or September meeting. Sterling looks vulnerable as the Bank of England drags it feet on tightening and a change in prime minister could happen quickly. USD/JPY risks higher levels, with FX intervention continuing to prove ineffective. Currencies backed by energy exports and hawkish central banks should prove insulated.

Emerging market currencies are coming under pressure, but investors and our team still like outperformance of the Czech koruna and the Hungarian forint. The Polish zloty looks set to lag given a less hawkish central bank. Idiosyncratic stories are also coming through where the Israeli shekel has been hit by both the tech sell-off and intervention.

At the forefront of the energy shock remains Asian FX. Policymakers are pulling out all the stops to halt the rot, but have their work cut out. Only the heavily controlled currencies, such as USD/CNY, look truly contained until this inflation shock/dollar rally has passed.