The US dollar struggled for demand early on Thursday even as Middle East tensions escalated. The US calendar includes weekly Initial Jobless Claims and June Existing Home Sales, while markets also watched central bank commentary. Late Wednesday, the US military said it hit 90 targets along Iran’s coastline, and Iran’s Revolutionary Guard then targeted US bases in Kuwait and Bahrain. Reuters reported Qatar’s prime minister urged diplomacy in a call with Iran’s foreign minister. Even so, crude oil edged lower, the USD Index stayed below 101.00, and US stock index futures rose between 0.2% and 0.7%.
Federal Reserve minutes from the June meeting said upside risks to price stability remained elevated, while downside risks to maximum employment had moderated somewhat, and most participants outlined scenarios where inflation could stay elevated, implying some policy firming might be warranted. In FX, EUR/USD rose towards 1.1450 and GBP/USD traded above 1.3400, a three-week high. Gold rebounded after a three-day slide, up nearly 0.8% to above $4,100, while USD/JPY fell below 162.50 after a 0.3% rise on Wednesday. The Bank of Japan’s quarterly report kept its assessment unchanged across all 9 regions, with most seen as “recovering moderately”.
—Volatility and Market Dislocation
We are seeing a major disconnect between escalating Middle East tensions and a weaker US Dollar. This suggests the market is pricing the conflict as contained, creating uncertainty and a case for higher volatility. We believe buying VIX call options is a prudent hedge, especially with the index recently trading near its 52-week low around 12.5, making volatility relatively cheap.
The Federal Reserve’s minutes clearly signal that further rate hikes are possible, yet the dollar is falling. This divergence will likely not last, and we see an opportunity in interest rate futures, anticipating the market will have to re-price for a more hawkish path. Historically, when the market fights the Fed, the Fed eventually wins, as we saw in the policy cycles of 2022 when initial doubts about rate hikes gave way to a strong dollar rally.
—Tactical FX and Commodity Trades
Given the clear momentum against the dollar, we are looking at buying call options on EUR/USD and GBP/USD. With EUR/USD pushing toward 1.1450 and GBP/USD hitting three-week highs, short-dated calls offer a low-cost way to participate in further upside. The European Central Bank’s own recent survey showed core inflation expectations remaining stubbornly above 3%, supporting the Euro’s relative strength.
The commodity space is telling two different stories, which presents a clear relative value trade. We recommend establishing long positions in Gold through call options as it rallies past $4,100 on safe-haven demand. Simultaneously, the drop in crude oil prices, with WTI futures falling 1.5% this morning despite the conflict, signals that supply fears are overblown and warrants bearish positions through put options.
In Japan, the central bank’s steady assessment means the yen’s movement is almost entirely a US Dollar story. The dip in USD/JPY below 162.50 presents a tactical opportunity to position for a sharp reversal if the dollar finds a footing. We are considering buying short-term USD/JPY call options to bet on a rebound, especially if today’s US jobless claims data comes in lower than the forecasted 215,000.
