Rising energy prices and intrest rates leave the euro vulnerable
It does not look like the Strait of Hormuz will be fully reopened for free passage anytime soon. Meanwhile, global oil inventories have declined considerably, which would normally suggest a rapid rise in oil prices. Until recently, however, that increase remained limited, likely because demand for oil has fallen as well.
Last week we noted that this is partly linked to the destruction of refineries in Russia and the Gulf states, but other factors are also at play. The release of national oil reserves and the normal market response to higher prices — more supply and less demand — are likewise having a dampening effect.
Even so, oil prices still seem likely to rise further, now that the Houthis are also joining the fighting. Inventories have already fallen so far that scope for further declines is limited, and replenishment will probably become necessary before long. As confidence in a swift end to the war diminishes, upward pressure on oil prices will increase.
The recent rise in oil prices of approximately 35 percent fits this picture. Combined with the global decline in refining capacity, this has already pushed U.S. gasoline prices back above four dollars per gallon. This trend, too, seems unlikely to reverse soon.
As a result, inflationary pressure is building further, particularly in the United States, where economic growth remains relatively strong. At the same time, the global economy has shifted from a predominantly deflationary to a more inflationary environment. Factors such as import barriers, the relocation of production to safer locations, ageing populations, and tighter labour markets are reinforcing this shift.
Since the U.S. economy is growing faster than the European economy, it stands to reason that the Federal Reserve will ultimately need to tighten policy further than the ECB. In theory, this should support the dollar, but the EUR/USD exchange rate has barely moved for quite some time now. This suggests that other factors are also playing an important role.
It is often pointed out that markets expect broadly similar rate hikes from the ECB and the Fed, and that concerns about U.S. public finances are increasing. While both arguments have merit, we do not currently consider them sufficient to fully explain the dollar's recent behaviour. After all, stronger U.S. growth could lead to greater second-round inflation effects, meaning the Fed will ultimately likely need to go further than the ECB. Furthermore, while U.S. public finances do represent a structural risk, they are not yet an acute problem. For now, higher deficits are actually supporting rates — and, by extension, the dollar — rather than weakening it.
There are, however, other forces at play as well, mostly negative for the dollar. The strength of the U.S. economy has its vulnerable sides. Relatively strong growth is being financed to a significant extent by a budget deficit of around six percent of GDP, whereas a surplus would actually be desirable at this stage of the cycle. An increasing number of investors are questioning whether this is sustainable in the longer term.
Demographic trends are shifting as well. The United States long benefited from relatively favourable population growth driven by immigration, but that engine has largely stalled.
In addition, investment in artificial intelligence is currently taking place on an unprecedented scale. Almost all major technology companies are investing enormous sums to secure their competitive position, often even using borrowed money. It remains uncertain, however, whether these investments will ultimately generate sufficient returns to justify current valuations. Moreover, China is demonstrating that comparable results can sometimes be achieved with considerably less investment, further intensifying international competition.
Political uncertainties are also increasing. Internationally, the United States' limited outcome in the conflict with Iran is raising questions. Domestically, social discontent is growing as well. Recent research shows that while the United States scores highly on financial measures, it lags well behind the best-performing countries on overall quality of life. This is fuelling discontent with current policy in Washington.
At the same time, both domestic and foreign investors are becoming increasingly concerned about the rule of law and democratic institutions. Fears that assets could, under exceptional circumstances, be frozen or even confiscated are undermining confidence. Given the so-called 'twin deficits', the United States is particularly dependent on a continuous inflow of foreign capital. Should that inflow diminish, U.S. interest rates will rise further and/or the dollar will come under downward pressure.
