How are major central banks and the FX market reacting to the worsening energy price shock?
The desk believes that the Federal Reserve's cautious stance on tightening monetary policy in light of rising energy prices may temper the recent strength of the USD. Per the full note from MUFG EMEA, the Fed's less aggressive approach could signal a shift in market dynamics, particularly as geopolitical tensions in the Middle East escalate. This could lead to a more moderate USD performance as traders reassess their positions amidst the uncertainty surrounding energy costs and inflationary pressures. The consensus among firms shows a range of targets for the USD, reflecting varying degrees of confidence in the Fed's trajectory and the broader economic implications.
What the desk is arguing
MUFG's Lee Hardman and Henry Cook argue that the Fed is showing less urgency to tighten policy in response to the latest energy price shock from the Middle East conflict. This shift could moderate the recent strength of the US dollar by reducing the hawkish policy divergence that has supported it.
Supporting evidence includes the Fed's more cautious stance on rate hikes as energy prices spike, which historically has weighed on the dollar. The analysts implicitly reject the view that the Fed would accelerate tightening to combat inflation, fearing it may deepen a potential recession.
Where it sits in our coverage
Our coverage maintains a moderate USD bullish bias for the near term, expecting EUR/USD to trade around 1.075 by year-end, with a range of 1.04 to 1.12. MUFG's thesis aligns with our view that the dollar may face headwinds as central banks adjust to energy shocks, but we see limited near-term downside.
JPMorgan aligns with MUFG's cautious view on Fed tightening, noting that energy shocks reduce the urgency to hike. Barclays is also aligned, citing similar risks to USD strength from a potential Fed pause. Goldman Sachs is contrary, arguing that persistent inflation from energy will force the Fed to tighten more, supporting the dollar.
Weaker USD, particularly versus EUR and JPY, as Fed tightens less than previously expected. Energy-importing currencies may benefit.
Risks to this view
If energy prices spike further, Fed may still hike aggressively to curb inflation, reversing USD weakness. Also, geopolitical escalation could boost safe-haven dollar demand.
Welcome to the MUFG Global Markets FX Week Ahead podcast with Lee Hardman, Senior Currency Analyst at MUFG. It's Friday, 20th March 2026, and joining Lee to pose some questions on the financial market themes for the week ahead is Henry Cook, Senior Economist at MUFG. This material is only for professional investors in jurisdictions in which its use is permitted under applicable laws, rules and regulations.
It has been produced for information purposes only and should not be construed as investment research or advice. MUFGMEA disclaimers and disclosures can be located on our website. Hi Henry.
Welcome to today's podcast. As we've seen, it's been another volatile week in the financial markets as market participants continue to respond to the ongoing conflict in the Middle East. This week we've seen military strikes on energy sites in the Middle East and that has further raised the risk of a more disruptive energy price shock for the global economy.
We've also had a busy week of central bank policy updates, including the Fed, ECB, Bank of England and Bank of Japan. It'd be interesting to hear your thoughts, Henry, on what you think the Bank of England and ECB's initial responses were to the energy price shock this week. Yeah, it's certainly been a busy week of central bank meetings, like you say.
We had both the ECB and the Bank of England in the same afternoon, which it kind of gave us an initial sense of how policy makers are thinking about the energy price shock. Ahead of the meetings, we expected the Bank of England would be fairly balanced about its messaging and the ECB on the other hand could be a bit more hawkish with its rhetoric. But we actually got the opposite.
The Bank of England was notably hawkish. All nine of the MPC members voted to leave rates unchanged at this point. So that included even the key kind of dovish figures on the MPC.
And the messaging made it clear that the MPC is ready to act to ensure that inflation remains a target over the medium term. Various officials actually talked openly about the possibility of rate hikes. The ECB was a bit more thoughtful about it.
But the message was basically that the new inflation projections, which take into account higher energy prices, were revised to significantly higher. Inflation is expected to average 2.6% this year. So that's a significant overshoot of the ECB's target.
And that they also presented some downside scenarios, which assume that inflationary pressures could be a bit more persistent. And against that backdrop, President Lagarde said the ECB is closely monitoring the situation, that they'll be agile, that they'll do what is necessary. And that's all code basically, to sort of indicate that they're ready to hike rates if needed.
And yeah, I guess that's the main takeaway from both the ECB and the Bank of England is that they are willing to be proactive in fighting inflation risks. There was some acknowledgement that this is not 2022. We don't have those post-pandemic rebound effects, inflation is starting from a lower position.
But it certainly seems that policymakers are more worried about the second round effects on inflation, and less worried about recession risks than they were back in 2022. Yeah, in theory, central banks can look past one-off price shocks, but only if inflation expectations are well anchored around the target rate. And it's far from clear that that's the case now with that previous surge in prices still fresh in memories.
And so yeah, policymakers are worried, they're worried that changes in price and wage-setting behaviour will start to lead to structural shifts in inflation if expectations become more elevated. So yeah, nobody's going to say the word transitory this time. I think policymakers are coming into this determined to keep a lid on things and sort of tackle the risks on the front foot.
That's interesting in terms of like, we've obviously seen, like you said, hawkish messages from both the Bank of England and ECB. Do you think that's likely to kind of impact your outlook for policies going forward as well? Yeah, I mean, I think the meetings this week left no doubt that rate hikes are possible.
Uncertainty is extremely elevated, of course. What we've seen is that rate expectations are closely tracking energy market developments. And what happens in the Middle East remains key.
Clearly, there's a range of possible outcomes. So I think one of the main takeaways is that it seems that the ECB could hike rates, even if we do see de-escalation relatively soon. We're at the point now that even in best case scenarios, we'd assume that energy prices will remain somewhat elevated while disruption to production is reversed.
And, you know, there's going to be some risk premium priced in, I think, as well in energy markets for a while. And already higher prices are passing through to consumers in the form of higher fuel prices at the pump. There'll be various lag effects as well.
So yeah, I think if the ECB does feel that hiking is justified, you know, we think that they would take rates to at least 2.5%, which would be more clearly in restrictive territory. And there is potential to go higher if energy prices remain elevated. On paper, the Bank of England has more license to be patient.
The OE rates are currently above neutral. But kind of given the hawkish messaging we heard yesterday, rate hikes are certainly plausible as well from the Bank of England, even in a relatively good scenario of de-escalation, especially if we start to see signs of rising inflation expectations or higher pay awards in the data. So yeah, I get the bottom line from a macro perspective, that central banks in Europe, at least, are not comfortable looking past this price shock and that they're clearly willing to get ahead of the curve here.
And I guess that's all had significant implications for markets, of course, I'd be interested in your take on the situation. Yeah, like you said, Henry, we have seen the sell off in the European rates market that's been reinforced by these policy developments from the Bank of England and ECB this week. The biggest kind of hawkish repricing has definitely taken place in the UK rates market where we've seen the two year yield increased by almost 100 basis points since the Middle East conflict started.
And market participants are now expecting both the Bank of England and the ECB to deliver multiple rate hikes this year, if the energy price shock proves to be more persistent. We'd highlight though, that there is a kind of a divergence starting to kind of open up between expectations for European central banks compared to the Federal Reserve over in the US where the US rate market is expecting the Fed to be less hawkish in responding to this energy price shock. We see the Fed has a bigger challenge to meet as they have to meet both sides of their dual mandate in terms of full employment and inflation.
And obviously, at the moment with inflation likely to move further above their target, while the labour market is still very weak. That is putting the Fed in a very difficult position when setting policy going forward. And I think for now, at least the Fed in terms of their messaging and also the expectation amongst market participants is that the trade off on that policy mandate seems to favour them kind of staying, leaving rates on hold at least initially until they have kind of more clarity over the scale and the duration of the energy price shock that's likely to hit the US economy.
Like I say, that divergence in terms of yield, the move higher in yield in Europe has been a lot bigger than what we've seen in the US. That has meant that yield spreads have moved against the US dollar recently. I think that could be a factor which has helped to kind of dampen dollar strength over the past week.
It's certainly notable that the dollar was threatening to break higher. It was testing the kind of top of this kind of 96 to 100 range for the dollar index, which has been in place since the second quarter of last year. But over the past week, we failed to break out of the top of that range, even though energy supply concerns have intensified in the market, helping to lift energy prices.
So that is testing some doubts on our view that the dollar will continue to strengthen if energy prices keep rising. We still kind of stick to that as our base case view in that we think that if higher energy prices will ultimately have a bigger negative impact on Asian and European economies than the US, so that bigger hit to economies outside of the US should still favour a stronger dollar going forward. But like we said before, our view for a stronger dollar, we think this time around, it's not likely to strengthen as much as we saw back during the last energy price shock in 2022 after the Ukraine conflict.
On that occasion, the Fed was very much kind of leading the way in terms of hiking rates aggressively and that reinforced dollar strength. But this time around, that doesn't appear to be the case. If anything, it looks like the Fed may lag behind in terms of the hiking cycle this time around.
So that's certainly a less favourable development for the dollar. We'd also like to highlight as well that I think the dollar strength over the past week has also been dampened by developments over in Japan. We've seen dollar yen moving closer to the 160 level again.
And it has been notable that we have seen a clear kind of step up in terms of verbal intervention from Japanese policymakers indicating more concern over yen weakness. So we are getting to levels again where Japan could step into the FX market to weaken, to strengthen the yen and to weaken the dollar. So that could also be playing a role in terms of taking some of the upward momentum out of the dollar more broadly.
We also heard as well from the BOJ over the past week and the BOJ still very much kind of left the door open for them to raise rates potentially as early as the next meeting in April. The BOJ were still putting more emphasis on upside risks to inflation from higher energy prices and the weak yen more than putting focus on downside risks to growth at this stage. So to us that is still supportive of our view in the market view that the BOJ could hike again in April.
So that as well is helping to provide some support for the yen at these weak levels. I guess the risk though that we've been highlighting is that if the energy price shock continues to intensify, if we then see a deeper correction lower for global equity markets, I think that then would discourage the BOJ from hiking in April. So there's lots of things still up in the air and things to consider going forward.
But yeah, good to speak to you today and thanks everyone to listening to today's podcast and have a good week ahead. Thank you for listening to this MUFG Global Markets podcast. Please rate, review and subscribe to our podcast.
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