FX daily: Dollar upside risks are rising rapidly

Crude has jumped, but still isn’t fully pricing in a fully-fledged new supply shock, meaning short-term risks remain on the upside for the dollar. So far, the rate differential is keeping EUR/USD afloat thanks to hawkish repricing of ECB expectations alongside the Fed’s, but further energy price increases should overcome rates as a primary driver.

USD: Room to rally

Short-term momentum is swinging back in favour of the dollar as the FX market is finally starting to take the Gulf re-escalation more seriously. Still, both oil (Brent is at $84/bl this morning) and the USD are showing reluctance to fully price back in another supply shock. That's despite the US reimposing a blockade in the Strait of Hormuz and oil inventories at worryingly low levels. Overall US crude inventories (commercial+SPR) were 730.8m barrels as of 3 July, the lowest since 1984.

This positive but contained USD reaction does seem a déjà vu of this spring. But conditions are different now. Reduced Fed guidance after a hawkish shift in June means allowing markets to speculate more aggressively on Fed tightening. Markets are now pricing in a roughly 50% chance of a hike in July, and 43bp by year-end.

Fedspeak remains crucial at this stage: yesterday, Chris Waller warned a hike may be needed in the short term if core inflation stays hot. Chair Kevin Warsh starts his first House testimony today, but he may follow his low-guidance approach and give little away. Barr, Goolsbee, Cook and Bowman are all speaking today.

Today's US June CPI release shouldn't severely dent markets' hawkish tendency. Headline should fall month-on-month due to lower energy prices, but core at 0.2% MoM isn't enough to dispel concerns about second-round effects.

Our call for the remainder of the year remains USD negative, primarily resting on another de-escalation and dovish Fed view. But risks, especially in the near-term, are clearly shifting to the bullish side for the greenback, with 102.0 potentially being reached rapidly in DXY if the Hormuz blockade continues.

EUR: Helped by rates

The EUR:USD short-term rate differential is – for now – helping to keep EUR/USD afloat in this Gulf re-escalation. The two-year swap rate gap has re-tightened around 15bp since the start of July, primarily because the rebound in oil prices happened at a time when ECB hike bets were dwindling, leaving more upside room to recover for EUR front-end rates.

We aren’t convinced this rate gap can offer sustainable support to EUR/USD if energy prices continue to rise though. Markets may find it harder to price in more than two ECB hikes by year-end (now, 46bp) considering the less hawkish stance by ECB officials of late, and the medium-term negative implications of an energy crisis – combined with Fed tightening – for the EUR, tend to outweigh the positive of EUR hikes. The spike in gas prices is particularly concerning, as it weighs on the eurozone’s terms of trade more than oil.

In a scenario where Brent returns to $90-100/bl and TTF around €55-60/MWh, a move to 1.10 becomes a tangible risk in EUR/USD.

NZD: Best performer in Gulf re-escalation

The Kiwi dollar is the best-performing currency in the G10 since the start of this week, riding the wave of last week’s hawkish repricing after an RBNZ rate hike. It’s a testament to how the FX market is very keen to reward currencies that can offer flexibility on the hawkish side for domestic central bank pricing, not just the positive commodity exposure (like for CAD, NOK, AUD).

Still, markets are now pricing in 60bp of tightening by year-end in New Zealand, which looks a bit too aggressive before seeing 2Q CPI, which is released on 20 July. AUD should recover some ground over NZD should this escalation fail to defuse.

CEE: Risk-off puts zloty and forint on the back foot

Regional currencies, along with the broader EM space, came under pressure yesterday following weekend headlines on the escalation of the US-Iran conflict. Risk-off sentiment and a stronger US dollar lifted EUR/PLN and EUR/HUF, while EUR/CZK stayed broadly stable. Hawkish CNB rhetoric should continue to cap EUR/CZK upside, leaving the koruna as the most resilient CEE currency. EUR/HUF is again approaching the 360 mark after two days of relief, a level that may act as resistance for many market participants. With our view of EUR/HUF in the range of 350-360 for the rest of the year, further upside should be limited.

By contrast, we still see EUR/PLN as vulnerable to further upside. From a rates perspective, despite yesterday’s PLN sell-off, the rate differential versus the euro is broadly unchanged and still points in our models to levels around 4.340. If markets were to price in the full rate cut expected this year, it would open the door to a move above that level. Today’s regional calendar is light, with only Czech May current account data due.

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