The currency market is factoring in an inflation surge driven by supply constraints

Global Currency Markets React to Iran Conflict

On Tuesday, currency markets experienced significant volatility as traders responded to a broadening supply-side inflation shock triggered by the ongoing conflict involving Iran.

The US dollar index surged by over 1% in early trading. Meanwhile, the euro lost nearly 1% against the dollar, and the British pound dropped approximately 0.8%. The dollar also appreciated by about 0.8% against the Swiss franc and made smaller gains versus the Japanese yen and Chinese yuan.

This upward momentum for the dollar is not limited to the index; it is also strengthening against a range of global currencies. Market participants believe the United States is less vulnerable to direct supply disruptions, though it is not completely shielded from the fallout.

These shifts indicate that investors are moving away from the typical risk-off approach—where assets like bonds, safe-haven currencies, and gold would usually rally—and are instead favoring assets that tend to perform well when interest rates are high.

According to economists at Goldman Sachs, “Negative supply shocks and threats to economic growth” are likely to drive global income redistribution as a result of the conflict, shaping currency performance worldwide.

For foreign exchange markets, the spike in energy prices is creating a terms-of-trade shock—a sudden shift in the relative prices of exports and imports. This dynamic can lead to higher import costs, expanding trade deficits, and reduced real incomes, which can weigh on a currency even if domestic bond yields are rising.

Macquarie FX and rates strategist Thierry Wizman noted that during extended supply shocks, countries that rely on oil imports, such as those in Europe and Japan, often see their currencies weaken. In contrast, energy-exporting nations like Canada, Brazil, and Norway may see their currencies outperform.

Wizman wrote, “In a prolonged conflict, oil-importing countries are likely to be the hardest hit, while nations with significant oil reserves and production capacity could see their currencies and economies fare better.”

Despite a notable increase in European bond yields—benchmark rates in the UK, France, and Italy all rose by over 10 basis points—both the euro and the pound declined. Investors have significantly scaled back expectations for near-term interest rate cuts from the Bank of England, and similar expectations for European Central Bank easing have also diminished.

However, these higher yields have not been enough to support the euro or sterling, highlighting concerns that ongoing energy disruptions could harm economic growth more than they would enhance central bank credibility.

Emerging market currencies that are heavily reliant on energy imports are also under pressure. Central banks in these countries have less flexibility to overlook energy-driven inflation due to the higher weight of fuel in their consumer price indices and weaker inflation expectations, which may limit their ability to cut rates, according to Goldman Sachs economists.

Challenges for Oil-Importing Currencies

Goldman Sachs analysts point out that the combination of slower growth and rising prices is especially difficult for currencies of oil-importing nations. For example, the Egyptian pound fell past the 50-per-dollar mark during Tuesday’s trading in Cairo, a significant psychological threshold.

ASSOCIATED PRESS

At present, currency markets are reflecting the shock by favoring the US and energy-exporting countries, while penalizing those that depend on imported fuel. Whether these trends intensify will depend more on how long oil and LNG shipments through the Strait of Hormuz remain disrupted than on daily news developments.

If commodity prices, including oil, stay elevated beyond the initial shock, Goldman Sachs suggests that foreign exchange markets may increasingly reward commodity exporters at the expense of importers.