What’s happening in the currency markets?
What has been particularly striking about currencies lately is how little the major players—the dollar, euro, pound, yen, and Swiss franc—have changed in value relative to one another. Why is this?
We believe this is primarily due to the enormous uncertainty surrounding the direction of the war in the Middle East and the future of AI. It makes a huge difference for major economies whether oil prices rise or fall and whether expectations for AI are overly optimistic or not.
Given this uncertainty, few positions are being taken by market participants in the foreign exchange market, and everyone is waiting to see what happens as much as possible. That is why exchange rates are changing very little. However, this also means that, as soon as it becomes clear which direction things are heading, significant movements can be expected.
Within this context, it is particularly striking that, even as tensions in the Middle East escalate, the oil price is showing little reaction to these developments. Given the circumstances, the price remains remarkably low. This is all the more surprising given that just a few weeks ago, many experts predicted that if the Strait of Hormuz remained closed for a while longer, physical shortages of oil, gas, helium, and fertilizer would arise. Prices for these commodities could then rise sharply.
Until recently, virtually no one expected the Strait of Hormuz to open anytime soon, but the oil price changed little as a result. This is likely because the reduced flow of oil through the Strait is being largely offset by a drawdown of inventories—particularly in China—higher oil production in the U.S., and, more recently, by a slightly increased number of ships that are still managing to pass through the Strait of Hormuz.
Another factor keeping oil prices low is the expectation that the US and Iran will eventually reach an agreement soon. It is generally believed that both Washington and Tehran will come under enormous political pressure if the war does not end quickly. Consequently, there is an expectation that the Strait of Hormuz will reopen fairly soon. This also explains why the oil price has fallen further over the past 24 hours on Trump’s statement that an agreement has practically been reached, while Tehran has not confirmed this at all.
In any case, we see it differently. This is because we believe Iran stands to gain significantly if oil prices rise substantially first. This would increase Iran’s revenue and put Trump under enormous pressure.
So here lies the difference. The markets assume that oil prices will gradually decline. This could push interest rates down and stock prices up. Furthermore, this would benefit Europe more than the U.S., because the U.S. is self-sufficient in energy, whereas Europe must import a significant portion of its energy. A lower oil price therefore pushes the EUR/USD exchange rate up.
If the Strait of Hormuz does indeed open up fairly soon, as is widely expected, the oil price will certainly fall. However, this is unlikely to happen very quickly, as stocks must first be replenished. It is even possible that, for safety reasons, countries may now want to build up additional reserves. This will then create high demand for oil in the first few quarters.
Central Bank Response
As long as the oil price remains around current levels or rises, this will, in principle, only cause a one-time increase in inflation. It therefore makes little sense for a central bank to react strongly to this.
However, the situation becomes much more problematic if higher oil prices also cause price increases for all sorts of other products that require significant amounts of energy or oil (so-called secondary effects). Higher inflation then takes on a much more structural character, especially if it also leads to higher wage increases. A central bank must take action against this.
The extent to which this will be the case depends heavily on economic growth. The higher the growth rate, the greater the secondary effects will be.
This creates a complicated picture, because lower oil prices are beneficial for inflation in and of themselves, but they also lead to higher economic growth. The latter, in turn, means more secondary effects.
It therefore depends on how quickly and by how much the oil price falls, and to what extent that also pushes down inflation and interest rates.
If oil prices fall sharply, the resulting downward pressure on inflation will undoubtedly prevail, thereby pushing interest rates lower. However, if, as we expect, oil prices decline only slowly after the Strait of Hormuz reopens, there will still be quite a few secondary effects, and inflation and interest rates need not fall significantly as a result.
Artificial Intelligence
Finally, a brief remark about AI. All stocks that have anything at all to do with AI have been going “through the roof” lately. In our view, this is clearly a mania/bubble. These always end badly. In this case, not because AI itself will prove a huge disappointment, but because its positive aspects are now being over-discounted. If we are proved right and stock prices start to fall significantly at some point, this will have negative consequences for the economy and thereby place downward pressure on interest rates for some time.
See full report: ICC Currencies Outlook
