Global currencies experienced significant fluctuations on Tuesday as foreign exchange traders factored in the impact of a widespread supply-side inflationary shock resulting from the conflict in Iran. The US dollar index surged over 1% in early trading, with the euro and sterling both declining against the greenback. Additionally, the dollar strengthened against the Swiss franc, Japanese yen, and Chinese yuan.
The market perception that the United States is less vulnerable to direct physical supply disruptions has led to the dollar gaining ground against a basket of other currencies. This shift indicates a move away from the traditional risk-off environment, where safe-haven assets like bonds, gold, and certain currencies would typically rally.
According to economists at Goldman Sachs, the prevailing theme in global income reallocation following the war will be negative supply shocks and growth risks, ultimately influencing how currencies perform. The surge in energy costs poses a terms-of-trade shock for currency markets, potentially leading to increased import bills, wider trade deficits, and decreased real incomes. This situation can exert pressure on a currency even when domestic bond yields are on the rise.
In times of prolonged supply shocks, oil-importing economies such as Europe and Japan often experience currency depreciation, while energy-exporting nations like Canada, Brazil, and Norway may see their currencies outperform. Countries with significant oil reserves are likely to fare better during a prolonged conflict, while oil importers could face challenges.
Despite a notable increase in European bond yields, the euro declined, reflecting investor concerns that sustained energy disruptions could have a more significant impact on growth prospects than on monetary policy credibility. Similarly, emerging market currencies tied to energy imports are under pressure as their central banks may have limited flexibility in managing energy-driven inflation, potentially restricting rate cuts in oil-importing economies.
The combination of weaker growth and higher prices poses a considerable challenge for oil-importing currencies, as demonstrated by the Egyptian pound weakening past a key level in response to the ongoing conflict. Currency markets are currently reflecting the shock through relative exposure, favoring the US and energy exporters while penalizing economies dependent on imported fuel.
The duration of any disruption to oil and LNG flows through the Strait of Hormuz will be crucial in determining how currency markets evolve. Should oil and commodity prices remain elevated even after the initial market disruption, structural winners and losers may become more apparent in currency markets, with commodity exporters potentially benefiting relative to importers.
