FX Daily: Fading geopolitical risk, focus on rate differentials
The desk emphasizes that geopolitical tensions in the Middle East have surprisingly failed to bolster the dollar, while focus shifts decisively back to interest rate differentials, as noted in the recent commentary source. Despite the backdrop of escalating US-Iran tensions, including US strikes on Iranian infrastructure and threats of a full blockade of the Strait of Hormuz, the dollar remains relatively stable owing to improving sentiment in risk assets and a decline in oil prices. Front-end rate implications are shifting, with the 2-year USD swap rate having lost ground this week, presenting a broader context where some investors are recalibrating their hawkish expectations for the Fed against improving outlooks overseas; currently 35 basis points of tightening is priced in for December 2023 while the euro has gained on the dollar amid expectations of ECB hawkishness.
What the desk is arguing
The desk frames this as a situation where fading geopolitical risks pose a challenge to the dollar, which isn’t gaining traction as one might expect amidst rising tensions. This stems from a fraying relationship between the US and Iran where fresh hostilities — including naval operations in the Strait of Hormuz — are triggering feedback but are overshadowed by rate differential play.
Significantly, the dollar has not reacted positively to the renewed harsh conditions, with the 2-year USD swap rate easing off its recent peak, erasing about half of the earlier rise that followed the geopolitical news. As a consequence, front-end rates are now more sensitive to shifts in other central banks' policies, particularly the ECB adjusting its stance, negatively impacting the dollar's comparative yield allure over the euro.
Market participants could be underestimating the potential for further escalation in tensions, which has historically led to non-linear spikes in oil prices and, subsequently, significant effects on currency dynamics, creating a fragile balance between rate-driven and geopolitically driven trades.
Where it sits in our coverage
For EUR/USD, our internal consensus target for December 2026 sits at 1.1750, with a range from 1.1200 to 1.2000. Notable per-firm forecasts include: - citi: Mar26 1.1300, Jun26 1.1100, Dec26 1.1000 - commerzbank: Mar26 1.1900, Jun26 1.2000, Dec26 1.2200 - goldman: Mar26 1.1800, Jun26 1.2100, Dec26 1.1200
The desk's thesis aligns broadly with the consensus targets, albeit leaning towards the upper end of the range forecasting a reversal through the second half of 2026.
How other firms see it
Several firms, including commerzbank and goldman, express a more bullish view on the euro against the dollar, reflecting recent hawkish swings from the ECB. Conversely, citi and hsbc stand at a more cautious stance, forecasting lower values down the line, indicating less confidence in euro resilience.
The short-term trajectory of USD/JPY is also worth noting as it is closely tied to these FX dynamics, particularly given the BOJ's ongoing ultra-loose policy stance compared to the Fed's potential tightening course.
How firms align with this view
Aligned with the desk view
Contrary positioning
Key takeaways
- 01Dollar remains range-bound despite escalating geopolitical tensions in the Middle East.
- 02Focus has shifted to interest rate differentials, particularly with shifting expectations for the ECB.
- 03Market participants may be underestimating the risks of further conflict and its impact on oil prices.
- 04Fading geopolitical risks have proven successful as a trading strategy at this juncture.
Market implications
Traders should monitor the EUR/USD around the 1.1434 level for signs of further recovery towards the upper consensus target of 1.1750. Additionally, risk sentiment and any developments in Middle Eastern tensions will provide crucial context for positioning.
Risks to this view
A significant reversal of the current view would be prompted by increased military actions in the Strait of Hormuz resulting in extended oil price spikes, or a sudden reassessment of U.S. interest rate policies that can shift yield expectations sharply.
EUR/USD — All Desk Targets
| Firm | Stance | YE 2026 |
|---|---|---|
Goldman Sachs | — | 1.1200 |
UOB | — | 1.1445 |
MUFG | — | 1.1800 |
Articles FX Daily: Fading geopolitical risk, focus on rate differentials Published 07:52 FX Share X LinkedIn E-mail Copy link Share X LinkedIn E-mail Copy link Download A week of revamped Middle East tensions has left the dollar broadly unchanged. Oil prices have come back lower, allowing risk sentiment and high-yielding EM FX to rebound. The risk is clearly that markets are too sanguine, but fading has been the successful strategy so far, and markets understandably remain laser-focused on front-end rate differentials Francesco Pesole , Frantisek Taborsky and Chris Turner The dollar is finding no support from a re-escalation in the Middle East USD: Stuck as markets fade geopolitical risk Markets are taking a decisively optimistic stance on fresh US-Iran tensions.
Multiple reports indicate traffic in Hormuz has dropped to almost zero in the past couple of days, and we have seen effectively no intent of de-escalation from either party. The US is reportedly striking Iranian bridges for the first time since April, and Iran is threatening a new full Hormuz blockade. Yet investors are probably clinging on to the fact that technical talks between the two parties are continuing, and Brent has dropped back to $76/bbl after briefly touching $80 on Wednesday, dragging front-end rates lower.
The 2-year USD swap rate has erased roughly half of the 10bp jump after the re-escalation – 35bp of tightening is currently priced in for December. The dollar is seeing no benefits from this situation. Fading geopolitical risk means continuous focus on rate differentials, which have moved against USD in some instances (e.g., vs the euro) by revamping hawkish expectations abroad.
Incidentally, the recovery in risk sentiment yesterday prompted a decent rebound in high-yielding EM FX after an unwinding of carry trades earlier this week. The risks here are obvious. Investors may be underestimating the chance of a new Strait of Hormuz closure and non-linear oil spikes.
The balance of risks remains on the upside for the dollar, although only a modest pick-up in oil prices and markets rapidly turning to headline fatigue would probably leave DXY pretty much where it is now. The data calendar is quiet in the US today, and there are no scheduled FOMC speakers. This morning, the yen rallied to 161.5 after Japanese Finance Minister Satsuki Katayama made a rare appeal for Japan’s pension funds to increase domestic asset holdings.
The FX reaction was probably exacerbated by stretched short positioning (35% of open interest, according to the latest CFTC figures), and it seems unlikely to drive a sustainable JPY recovery on its own. With appetite for JPY-funded carry trades intact after Wednesday’s wobble, risks remain on the upside into the next round of intervention for USD/JPY. Francesco Pesole EUR: Don't downplay downside risks The Middle East military re-escalation has prompted a moderate re-tightening in EUR/USD short-term swap rate differentials.
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