Rising oil prices and escalating Gulf tensions have pushed a sharper move in US rates than in FX, with Brent briefly touching $80/bl and lending support to a more hawkish Federal Reserve backdrop. The US dollar has stayed firmer against low-yielding currencies, while carry trades in Emerging Markets have been unwound. The US Dollar Index (DXY) is seen around 101.00, with scope to return towards 101.50.
The latest flashpoint followed a reported breakdown in US-Iran negotiations and an exchange of fire that extended overnight, including US military strikes on infrastructure targets in northern Iraq, described as the first such infrastructure strike since early April. Separately, the Federal Open Market Committee minutes for June laid out two rate paths: a delayed cut if inflation eases, or an earlier hike if inflation remains elevated. Markets showed limited immediate reaction in the dollar and US rates, suggesting attention may shift to next week for clearer Fed direction.
Fed Outlook Bolstered By Oil Prices And Inflation
Elevated energy prices, with Brent crude recently pushing past $95 a barrel, are reinforcing the Federal Reserve’s hawkish position. Renewed tensions in the Strait of Hormuz have pushed short-term interest rate expectations higher. This environment provides fundamental support for a stronger US dollar.
Recent inflation data, which came in at a stubborn 3.4% last month, complicates the Fed’s path toward easing policy. Fed funds futures are now pricing in less than a 50% chance of a rate cut before the end of the year. We believe this dynamic will keep the dollar well-supported against any dips.
Dollar Strength And Rising Market Volatility
Consequently, we see the US Dollar Index, currently trading around 106.50, having the potential to test the 107.00 level in the coming weeks. Derivative traders should consider long dollar positions, particularly against low-yielding currencies like the Japanese Yen. The wide interest rate differential makes strategies like buying USD/JPY call options attractive, especially as the pair tests multi-decade highs.
This strength in the dollar is causing an unwind of popular carry trades in some emerging markets. Market volatility has picked up, with the VIX index climbing from its lows below 14 just last month, making these trades riskier. We would be cautious about holding unhedged positions in high-yielding currencies until the geopolitical situation stabilizes.
