The Middle Eastern geopolitical landscape has undergone a significant shift following Israel’s military action against Iran’s nuclear facilities, a move that has sent ripples through global markets, particularly in the realm of energy prices and foreign exchange (FX) markets. This incident, marking a severe escalation in the longstanding tensions between Israel and Iran, warrants a deeper exploration to understand its implications on global economics, currency valuations, and the strategies of major central banks.
In the wake of the Israeli offensive, there was an immediate surge in energy prices, with oil prices witnessing an approximate 8% hike. This situation arises against the backdrop of Iran’s pivotal role in the global oil supply chain, a nation that sits at the heart of a region rich in petroleum resources. The targeting of nuclear installations, seen as a qualitatively different and more severe action than past skirmishes between these nations, has compelled markets to factor in a higher risk premium. Concerns mount over the potential for further escalation, such as actions that could threaten the Strait of Hormuz, a critical chokepoint through which a significant portion of the world’s petroleum circulation passes. Should this vital passage be disrupted, the repercussions on global supply chains and energy prices would be substantial.
Amid these tumultuous developments, the US dollar has found itself in a stronger position across the board. Traditionally, a spike in oil prices, coupled with geopolitical instability, would drive investors towards the perceived safety of the dollar. However, recent deviations in market patterns have somewhat muted this effect, with equity and bond market dynamics playing a more pronounced role in shaping the dollar’s valuation. Nevertheless, the underlying insecurities ignited by such conflicts undeniably infuse volatility into FX markets, driving cautious strategies among investors and policymakers.
The Federal Reserve (Fed), already navigating a complex landscape of tariff-induced price pressures set to unfold, now faces augmented inflationary risks due to rising crude prices. These developments may lend weight to a more restrained approach to monetary policy adjustments in the near term. Within this context, the sentiment and future outlooks presented by key economic indicators and surveys, such as those from the University of Michigan, gain heightened significance, offering insights into consumer expectations and economic sentiment amidst evolving geopolitical tensions.
Turning our gaze towards Europe, the Euro has expressed vulnerability to the upheaval in energy markets, a consequence of the region’s sensitivity to shifts in fuel prices due to its significant reliance on imported energy. The Euro’s response to these events underscores the challenges faced by the European Central Bank (ECB) in navigating monetary policy amidst heightened market volatility. These circumstances could potentially delay contemplated policy easements, reflecting a strategic recalibration in response to unfolding geopolitical and economic conditions.
The United Kingdom, too, finds itself grappling with domestic economic pressures, now compounded by the volatile geopolitical landscape. Recent data depicting contractions in economic growth and employment add layers of complexity to the nation’s fiscal and monetary policy pathways. The British pound, therefore, faces additional pressures, navigating through a confluence of domestic and international challenges.
In Central and Eastern Europe (CEE), nations are confronting inflationary dynamics that beckon a reassessment of monetary policy stances. Surprising spikes in inflation rates across the Czech Republic, Hungary, Romania, and Poland signal underlying economic strains that may necessitate more hawkish policy responses than previously anticipated. Such conditions present a nuanced picture for CEE currencies, suggesting potential divergences in their trajectories as central banks adjust rates in response to inflationary pressures.
This intricate tapestry of geopolitical tensions, economic policy challenges, and market responses highlights the interconnectivity of global events and their capacity to shape economic landscapes far beyond their immediate epicenters. As the situation continues to unfold, the implications for FX markets, central bank strategies, and global economic stability remain a focal point for analysts, policymakers, and investors alike. Understanding these dynamics requires a multifaceted analysis that considers not only immediate price movements and policy reactions but also the longer-term geopolitical strategies and economic fundamentals that underpin these shifts.
The Israeli strike on Iran’s nuclear facilities has sent spiking and has offered the oversold and undervalued a catalyst for a rebound. The energy price shock is generally disliked by the euro and gives the an argument to stay cautious. We see more short-term downside potential for
USD: Geopolitical Risk Opens Room for Brief Dollar Rebound
The dollar is stronger across the board this morning after Israel attacked Iran’s nuclear facilities. The main transmission channel from this specific geopolitical risk and FX is the price of oil, which has rallied around 8% since the Israeli strike. In other conditions, the rally would likely be much larger than the roughly 0.75% rebound from the overnight lows we have seen so far, because the dollar would also benefit from the negative shock in equities and bonds. But USD’s traditional correlations have disappeared of late, and it’s likely that the 1.5% drop in is doing more to cap gains.
What matters most for FX at this stage is the depth and length of the Middle East escalation’s impact on oil prices. We strongly recommend a read of our commodities team’s analysis on this topic here. The key difference from previous Israel-Iran standoffs is that nuclear facilities have now been targeted, and while oil production does not seem to be affected just yet, markets have to add in a bigger risk premium given the crucial role of Iran in global oil supply. The next key risk is whether further escalations lead to disruptions in the Strait of Hormuz, which can seriously impact flows from the Persian Gulf, where most of OPEC’s spare capacity incidentally sits.
While it’s hard to speculate on the situation at the moment, Israel has announced more strikes will follow and Iran’s retaliation has already started. The risks now point more definitively towards a prolonged period of tension, in contrast to recent episodes. And we think this could continue to take some pressure off the dollar. While the US may well intervene with oil reserves to curb excessive price spikes, the new risk premium added to crude means inflationary risks are rising at a time when the bulk of the price impact from tariffs in the US is set to materialise.
We had felt the USD negative reaction to the soft print was exaggerated, and new geopolitical tensions give the Fed another argument to stay cautious, arguing for that move to be scaled back. Today, the US calendar includes the University of Michigan surveys, which have generally painted a grimmer picture of and than other indicators.
Given the large impact on equities, the and are performing strongly alongside the dollar this morning. Unless this escalates into a commodity shock significant enough to trigger concerns over the economic strain on energy importers, we still see the yen as the most attractive hedge out there.
EUR: Not Liking the Oil Rally
The euro generally dislikes geopolitical shocks leading to higher energy prices, and has therefore detached from JPY and CHF in early price action after the Israeli strike on Iran. This is a trigger for an unwinding of stretched longs on EUR/USD, which, according to our model, briefly reached a 2-standard-deviation overvaluation relative to short-term drivers yesterday. That is just above the 5% misvaluation, which we have assessed as the peak, where further rallies would need to be justified either by a substantial shift in rate differentials (higher EUR short-term rates or lower USD short-term rates) or another material deterioration in the US debt market. That overvaluation sits at 4% after this morning’s correction.
From a European Central Bank perspective, oil market volatility likely endorses its cautious tone on further easing, and potentially pushes the chances of the last 25bp cut of the cycle more to 4Q rather than 3Q – mirroring the current market preference.
Anyway, we’ll likely need to wait for next week’s ECB speakers to get a better sense of what this all means for monetary policy. And given the fast-moving geopolitical situation, it is definitely too early to draw conclusions just yet. EUR/USD will likely follow that situation closely and primarily via the oil price channel. But we think the starting point was already quite rich for the pair, and a return to the 1.14-1.15 seems entirely appropriate.
GBP: A Rough Week Gets Rougher
The week has been a rather negative one for the pound’s domestic drivers. April surprised yesterday with a 0.3% month-on-month contraction, and our economist notes how growth may well get worse later in the year. Adding to that, payrolls dropped significantly in May, and a relatively uneventful spending review event did very little to suggest the government can dodge tax rises at the Autumn budget.
In line with our call, has broken above 0.8500, and prolonged geopolitical turmoil in the Middle East should drive further gains in the pair, where we retain a bullish bias.
Cable has potentially a wide room for downside correction given how expensive it looks relative to rate differentials. But we have seen how structurally bearish USD bets are preventing dollar gains from being sustainable. So we’d be more cautious on that side.
CEE: Higher Inflation Supports Higher Rates for Longer
This week’s inflation data has shown that the problem of rising prices has not been resolved, while divergence within the CEE region continues.
- In the Czech Republic, Tuesday’s number confirmed the headline rate at 2.4% year-on-year while core inflation moved above the central bank’s forecast at 2.8%. The Czech National Bank thus has good reason to turn hawkish, and the August rate cut in our forecast is a question mark. There is a possibility that the CNB will end the cutting cycle for some time.
- Wednesday’s numbers in Hungary also surprised to the upside with a rise to 4.4%. Although core inflation has slowed, the central bank remains hawkish, and our baseline remains no rate cut this year, though the situation may still change in the second half of the year.
- Yesterday’s numbers in Romania also showed a slight upside surprise with a rise from 4.9% to 5.5%, slightly above market expectations. We have recently lifted our 2025 year-end inflation forecast to 6.0%, and we now see at most a single 25bp rate cut likely at the National Bank of Romania’s final meeting of the year.
- The week ends today with final numbers in Poland, which should confirm the earlier flash estimate of 4.1%. The details will allow for a more precise calculation of core inflation, which excludes food and energy prices, and it probably moderated to 3.3% YoY in April. Inflation continues to surprise to the downside and is expected to fall to the central bank target in July, leaving substantial room for monetary easing from the National Bank of Poland.
- Current account numbers will be published in Poland and the Czech Republic.
In the FX market, a weaker US dollar further supports stronger CEE currencies. On the other hand, yesterday we saw a slight correction in rates after a sharp rise in previous days – a move that also pared back recent FX gains. However, the picture for CEE currencies still looks more bullish. The CZK in particular should continue its gradual gains, while PLN and HUF seem more of a mix to us.
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