Market Brief: Dollar powers higher as Mideast conflict widens

The dollar is steamrolling its major rivals for a second consecutive session as geopolitical risks and inflation fears reinforce one another. With the conflict in the Middle East showing few signs of easing, and shipping through the Strait of Hormuz effectively halted, traders are unwinding cross-border positions and retreating to the world's deepest and most liquid financial markets in a pattern known to currency traders as the "dollar smile"*. Ten-year Treasury yields are flirting with the 4.10 threshold after their sharpest single-session rise since October, North American equity futures are setting up for a bruising loss at the open, and energy markets remain in a state of acute stress: crude prices are up more than 15 percent from Friday, while European natural gas prices have surged almost 90 percent.

There is still little clarity on what motivated the US to strike Iran now, what it hopes to achieve, or how long the conflict could go on. Administration officials have offered a succession of contradictory rationales, variously citing the need to halt Tehran's ballistic missile programme, prevent it from acquiring a nuclear weapon, avenge American casualties, support the protest movement, achieve outright regime change, or (in the most recent twist) defend against Iranian retaliation after an Israeli attack. As US and Israeli airstrikes continue and Iran presses ahead with missile and drone attacks across the Gulf, President Trump hasn’t ruled out the deployment of ground troops, telling CNN "whatever it takes," and has said of the campaign's timeline: "Right from the beginning, we projected four to five weeks, but we have capability to go far longer than that."

Most market participants think the conflict will prove brief and well-contained from a macroeconomic perspective, but many are nonetheless taking out hedges against a stagflationary shock to the global economy, and are rapidly repricing expected monetary policy trajectories.

In the US, traders in the Fed funds futures markets are now fully pricing the next rate cut for September rather than July, and bets on a third reduction this year have all but evaporated. Yesterday, the Institute for Supply Management said its measure of manufacturing sector activity climbed at a steady pace in February, but a narrower indicator of prices paid at the factory gate jumped to a three year high, with many respondents singling out the impact of tariffs in driving costs higher. As one put it, “Today, American-produced commodities like steel and aluminum are the highest-priced in the world, by far. Hence, the Section 232 tariff policy is having the exact opposite effect of their intention on an American manufacturer like us: It is raising prices while lowering demand and profitability”. Former central bank chair and Treasury secretary Janet Yellen, speaking at a conference in Long Beach, California, noted that inflation was already running roughly a percentage point above the Fed's 2 percent target before the conflict erupted, with tariffs responsible for around half a percentage point of the current 3 percent pace, and warned the war in Iran "puts the Fed even more on hold, more reluctant to cut rates than they were before this happened."

The Canadian dollar is holding up better than most of its peers despite the broader dollar advance, underpinned by the country's status as a net oil exporter. The relationship between crude prices and the loonie has grown less reliable in recent years as the prospect of a fresh investment cycle in Canada's energy sector has receded—limiting the currency's ability to extract its traditional dividend from rising energy prices—but the correlation tends to increase as nominal crude benchmarks push through the $75-per-barrel mark (as they’re doing now).

On the other side of the Atlantic, euro area inflation unexpectedly accelerated last month, exacerbating background fears of an energy price shock that could force the European Central Bank off the sidelines earlier than previously anticipated. Core prices rose 2.4 percent in the year to February, up 0.2 percentage points from January, while the services component—the measure most closely watched as a gauge of underlying demand—quickened to 3.4 percent from 3.2 percent. The numbers arrive as a production halt in Qatar has driven natural gas prices to their sharpest rise since Russia's invasion of Ukraine in 2022, compounding the inflationary picture and pushing the implied probability of an interest rate hike this year to nearly 60 percent.

The gilt market has not been spared. Yields rose sharply this morning as traders scaled back expectations for Bank of England easing ahead of the March meeting, with the implied probability of an imminent rate cut collapsing from above 85 percent on Friday to below 25 percent. Sterling is under pressure, reflecting the UK's structural vulnerability as a net importer of both oil and gas—a dependence that makes it more exposed than most to a sustained rise in global energy prices.

Japanese government bond yields are also rising as surging energy import costs feed through to domestic inflation expectations, and the yen has continued to drift towards the 160 level against the dollar—a threshold that Tokyo has historically treated as a trigger for intervention. Official jawboning efforts have grown louder, but carry limited conviction: last month's "rate checks" appear to have been conducted at the behest of a certain Soros acolyte at the US Treasury official, not by Japanese authorities themselves, and markets have drawn their own conclusions.

China’s yuan is pushing higher, making it an idiosyncratic exception to the global washout. The People’s Bank of China lifted its daily reference rate for the renminbi by the most since August last night, following a long-standing practice of demonstrating confidence in the currency ahead of the National People’s Congress (the government’s annual rubberstamping session), but also, arguably, a signal that Beijing sees a stronger exchange rate as a useful buffer against higher imported energy costs. That appreciation is unlikely to be sustained at the same pace: the central bank will be mindful that an excessively strong renminbi erodes the export competitiveness that China's economy is currently leaning on.

Bottom line: Conviction in an early end to the conflict in the Middle East is fading quickly, shaking confidence in the assumptions that underpinned currency markets at the beginning of the year. Market participants should expect volatility to stay high and clear-cut directional trends to remain absent until the White House delivers an all-clear signal.

*The dollar smile, a theory originally posited by Stephen Jen, holds that the US dollar tends to underperform when the world economy is stable, but strengthens when America significantly outperforms its rivals or when financial crisis or recession strikes.

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Notes: DXY: Dollar index, ON: Overnight movement, DMA: Daily Moving Average, Pivot points are calculated on a one-month basis, 3-month and 10-year spreads are against USD, Implied V.: implied at-the-money option volatility

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