Market Brief: Rate differentials overwhelm other drivers in keeping dollar aloft

The dollar is holding near a one-year high and Treasury yields are climbing even as oil prices fall another 2%, with investors returning from the holiday weekend to find that hawkish signals from last week's Federal Reserve meeting are overwhelming the terms-of-trade effects that had dominated currency markets since the war began. With rate differentials having tilted sharply in the dollar's favour since newly-installed Fed chair Kevin Warsh let the hawks control the early narrative, most major currencies—including the euro, pound, Swiss franc, Canadian dollar and Australian dollar—are down roughly 1.5% against the greenback in the past five days, leaving the intervention-prone Japanese yen as the lone exception, down just 0.85%.

The pound barely flinched this morning when Prime Minister Keir Starmer announced his resignation. Attention now turns to whether the Labour Party will hold a competitive leadership contest or stage a coronation of its preferred candidate. In his resignation speech, Starmer said he would ask the party to set out a timetable for the process, with nominations opening on July 9th and closing when Parliament breaks for summer a week later, ensuring a new leader is in place before the House returns in September. He will remain as prime minister until the contest is complete.

A very small volatility premium has been priced into sterling, suggesting markets expect a smooth handover, with Starmer's successor keeping a steady hand on the fiscal tiller. After this morning’s endorsement from Wes Streeting, Andy Burnham, the Mayor of Greater Manchester, is the overwhelming favourite—and would become the country's seventh* prime minister since the Brexit referendum in 2016. Mindful of the gilt-market turmoil that accompanied Liz Truss's brief tenure in 2022, Burnham has moved quickly to reassure investors, pledging to operate within the existing fiscal rules and honour Labour's 2024 manifesto commitment not to raise taxes on working people. We nonetheless expect the pound to underperform in the near term as traders downgrade expectations for monetary tightening from the Bank of England.

The global geopolitical environment remains fragile. After talks briefly derailed over the weekend when Tehran declared the Strait of Hormuz closed and President Trump threatened in a social-media post to restart attacks, mediators in Pakistan and Qatar this morning said the warring parties had agreed on a roadmap aimed at reaching a final deal within 60 days. There has been little sign of a sustained reopening—observed traffic through the strait remains negligible**—but markets are pricing one in nonetheless, betting that the US has lost any appetite for re-escalation***.

More broadly, the dollar outlook has seemingly been reset by last Wednesday's Federal Reserve meeting. Inflation expectations across the committee snapped sharply higher in the June summary of economic projections: nine of 18 officials projected at least one hike by year-end, five projected two, and one expected three, marking the largest shift in the dot plot's profile since its introduction in 2012. Warsh's first press conference left no ambiguity. He called inflation a choice, insisted price stability was the committee's paramount objective, and implied that the Fed would look through any supply-side disinflation stemming from the Iran peace deal. Markets are putting the odds of a hike by September at 95%, helping support bullish bets on the greenback.

This looks overdone. Just as rate-cut pricing looked exaggerated before the Iran conflict, rate-hike expectations now look stretched. Underlying inflation pressures in the US economy have accelerated, but not enough to justify an aggressive tightening cycle, and a near-30% drop in oil prices should weigh on inflation expectations in the months ahead, giving the central bank room to stay on hold for longer. Fed officials could begin walking investors back in speaking engagements this week. As the authors of Mobs, Messiahs, and Markets observed long ago, crowd sentiment swings reliably between greed and fear but rarely pauses at doubt. This might be a good moment to pause.

*Italy has had only four prime ministers over the same period. Italy, where leaders have historically had shorter shelf lives than mozzarella!

**Note that this chart depicts movement among tankers with their automatic identification system (AIS) transponders on, and necessarily omits those that have transited the Strait while "dark".

***Not to put too fine a point on it, but this reflects the political reality facing President Trump: the war is deeply unpopular among American voters and represents a major headwind for the Republican party ahead of the November mid-term elections. Markets are betting that bouts of Iranian intransigence won't derail US attempts to extricate itself from the conflict.

Market Overview

Data as of 7:15 AM EDT

Notes: DXY: Dollar index, 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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