USD: Rate expectations and crisis hedging support – Commerzbank

Commerzbank’s Michael Pfister highlights that the US Dollar (USD) was a key short‑term beneficiary of the Middle East conflict, even if much of that strength has since reversed. He stresses that markets have repriced toward fewer cuts and possible hikes by the European Central Bank (ECB) and Bank of England (BoE), and argues that low implied volatility and persistent geopolitical risks make current levels attractive for hedging Dollar exposure.

War premium fades but support remains

“The latest rumors that Iran and the US are on the verge of an agreement make such an escalation indeed seem less likely. Nevertheless, I believe the FX market should consider three points:”

“1.First, in the wake of the oil price shock, interest rate expectations have shifted significantly toward fewer rate cuts and more rate hikes, even though the ceasefire has provided some relief.”

“Although the market has adjusted its rate expectations in light of this news, it still expects two rate hikes from the ECB and at least one from the BoE by the end of the year. A significant correction is still on the horizon if there is a lasting end to the war in the Middle East and the Strait of Hormuz reopens.”

“2.It is somewhat surprising that implied volatility is trading at such a low level again. Even if the war were to end, surely the next crisis is waiting for us. The US president has this week once again turned his attention to his favorite topic: the Fed. Geopolitically, Cuba appears to be his next target, not to mention his regular attacks against NATO. For market participants doubting that we are running out of crises, current levels are likely attractive for hedging.”

“3.The US dollar has been one of the biggest short-term beneficiaries of this war, even though its strong performance has now been almost entirely priced back out. But the market is still uncertain about risk reversals. There is a long way to go before reaching prewar levels.”

“If you are betting on a return to the pre-war world as a market participant (including low volatility), then these levels would be attractive.”

(This article was created with the help of an Artificial Intelligence tool and reviewed by an editor.)