How has the USD been impacted by geopolitical risks?

Welcome to the MUFG Global Markets FX Week Ahead podcast with Lee Hardman, Senior Currency Analyst at MUFG. It's Friday 23rd January 2026 and joining Lee to pose some questions on the financial market themes for the week ahead is Sarah Mackey, an MUFG Graduate Analyst. This material is only intended 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. MUFG EMEA disclaimers and disclosures can be located on our website. Hi everyone, welcome back to a Friday podcast.

I'm here with Lee. Hi Lee, how are you? I'm good, thanks.

How are you? Doing good. Always happy on a Friday.

So let's start off with the U.S. and talk about the Greenland tensions between the U.S. and Europe. So essentially, President Trump wanted to buy Greenland and if a deal was not reached with Europe, then he would impose tariffs in February to his fellow NATO members and then increase those tariffs in June. But this has since been retracted and the U.S. dollar actually rebounded modestly after he dropped his tariff threats.

And there have been heightened U.S. policy uncertainty under the Trump administration. So relating to foreign policy, trade policy and interference with the Fed's independence. All of these have contributed to a weaker dollar over the past year.

And there also have been indications from the Supreme Court that they're likely to rule against President Trump's decision to fire Fed Governor Lisa Cook. So my question to you is, how are you incorporating all of this uncertainty of, you know, the U.S. geopolitical tensions, U.S. policies, how are you incorporating that in your baseline dollar forecast? Yeah, it's a good question.

Like you said, last year when we did see the spike in U.S. policy uncertainty after the Liberation Day tariffs, the reaction in the FX market was that the dollar sold off sharply as we saw in foreign investors move to increase their hedging of their long U.S. asset exposures, which led to dollar selling in the FX market. We still think that this will continue going forward against the development at the start of this year, like you've highlighted with regards to Greenland and Venezuela and even Iran. Those developments kind of are just a reminder that the level of policy uncertainty for the U.S. is set to remain elevated.

So to us, these developments should continue to encourage foreign investors to increase their hedges on U.S. asset exposures. And that remains, I think, a headwind for the dollar going forward. Interestingly, over the past week in terms of the price action, we have seen the dollar weaken, even though U.S. yields have been moving higher as the markets move to pare back expectations for further Fed rate cuts.

So that kind of divergence between yield spreads and the dollar is unusual and it does potentially highlight there that investors are attaching more of a kind of risk premium into the dollar and that is leading to some underperformance, certainly at the start of this year. Do you think there's a loss of confidence in U.S. policymaking? I think certainly that what we've seen over the last kind of 12 to 18 months is certainly chipping away at confidence in U.S. policymaking and that in itself, we think ultimately is more dollar negative.

Like obviously, there is the risk in the future of even bigger dollar selloffs. But for that to happen, I think we'd need to see something more significant, such as a bigger hit to the Fed's independence. That's what we're watching closely in the coming years.

And what about the recent foreign selling of U.S. assets? Is that a sign of a structural shift in U.S. demand, sorry, dollar demand or a response to political noise? Yeah, like we don't fully buy into the kind of sell U.S. asset trade like we did see briefly earlier this week, some kind of triple selling of U.S. treasuries, equities and the dollar.

But by and large, as we saw even after the Liberation Day tariff announcement last year, yes, there was a very brief period of U.S. asset selling, dollar weakness. But what we saw quickly reemerge was strong foreign demand for U.S. equities and also treasuries as well. So it was last year that the dollar week was definitely more about the hedging flows.

And we continue to think that's really the most likely kind of path forward rather than any kind of big diversification, kind of selling down of U.S. assets. OK, well, that makes sense. I wanted to move on to Japan because the yen has been volatile after the Bank of Japan's latest policy meeting.

So the yen initially weakened, helping to uplift, you know, dollar yen to a high of 159.23, and then it dropped abruptly to a low of 157.37. There's speculation over whether Japan intervened in the FX market, or this could be just nervousness amongst market participants over rising risk of intervention. So how likely do you think it is for intervention to take place?

Yeah, like we've been saying for some time now, we are getting closer to levels in dollar yen where we think Japan would be certainly a lot more sensitive over yen weakness and would potentially step into the market. Like you say, we don't have kind of confirmation officially from Japan that anything happened earlier today in terms of the FX market action. But you say the kind of initial take is that we think most likely it's not intervention.

But yeah, we don't know for sure at this stage. But it does kind of highlight, like you said, that investors are kind of becoming more and more nervous that eventually Japan will step in if the yen continues to weaken. For us, we think the fundamentals right now continue to favor kind of yen weakness in the near term ahead of the snap election on the 8th of February.

We've still got a fiscal risk premium that's being priced into the yen that's weighing on the yen performance. And as we saw at the start of this week, Prime Minister Takahashi pledged to suspend the health tax on food for two years. That's just added to those fiscal risks.

So we don't see those fiscal risks going away anytime soon. And equally, on the other hand, the latest BOJ update today as well still indicated that they're not yet willing to send a much stronger message to kind of push back against yen weakness. Certainly, the updated forecast and some of the communication from the BOJ does indicate that the April policy meeting is on the table in terms of hiking rates.

But we're still talking about three to four months before the next hike from the BOJ. And if that happens at a time when the Fed looks more and more likely to keep rates on hold through the first half of this year, at least until the new Fed chair is in place in June. And we have an environment where there's a lot of kind of risk taking from global investors, more optimism over global growth and low market volatility, which is all supportive for yen funded carry trades.

It's difficult to kind of see what's going to turn around the yen weakening trend at this point in time, unless, like you say, Japan ultimately has no other choice but to step in and support the yen. Yeah, as you said, in today's policy meeting, Bank of Japan, they decided to leave rates on hold after resuming rate hikes at the previous meeting in December. So we're not, the Japanese rate market is not expecting a rate hike until April, as you said.

And I was just wondering, do the current fiscal concerns that you've mentioned change the expectations for the Bank of Japan's reaction function? And do you think the yen requires more attention? Well, I think the fiscal concerns could play into the BOJ's reaction function.

Like you say, if we continue to see a loss of confidence in the JGB market, then the initial thing that they would have to consider would be whether, when to kind of step in and potentially support the JGB market, as they've said in the past, that they are willing to increase purchases of JGBs to provide more stability for the market when there's disorderly price action in the market. And certainly the price action we saw earlier this week, particularly at the ultra long end of the curve, would be kind of more along the lines of being described as disorderly. So that's certainly one thing that they could do.

It would be to step up purchases, at least temporarily, in the JGB market. I think if they did that, though, the risk then would be that the market would see that as something which could trigger a sell off in the yen, potentially as a form of stepping up quantitative easing, which would be seen as loosening monetary policy and playing into that yen weakening fears in the market. And like I say, if the yen continues to weaken as well, then I think the BOJ has been indicating recently and at today's policy meeting that the yen weakness is becoming a bigger problem for them and that it could be increasing upside risks to their inflation outlook.

And that then would obviously put more pressure on them to bring forward their timing of the next rate hike in Japan. All right. Thank you.

Lastly, I want to talk about the UK, because we had some inflation data come in. So it was revealed that there was a modest pickup in inflation into year end. The December year on year rate picked up from 3.2 to 3.4 percent.

And so this is a 0.1 percentage point higher than expected. And the core rate and the services CPI rate were also 0.1 percentage points weaker than expected. And the inflation data followed by the jobs data clearly underline a worsening UK labor market.

So how does the divergence between a weakening UK labor, the weakening UK labor data and the still elevated services inflation feed into your expectations for the Bank of England's easing path? Yeah, like our view in terms of the inflation data is that there were a couple of kind of temporary seasonal factors like higher airfares, which lifted inflation in the latest report. But it doesn't really change our view that the trend for inflation over the next kind of three to six months should be that inflation falls back more quickly, closer to the Bank of England's 2 percent inflation target.

So if that does materialize as we anticipated, it should kind of create some more room for the Bank of England to keep lowering rates this year. And like you said as well, with the labor market continuing to remain weak, that also leaves the door open for the Bank of England to keep gradually lowering that policy rate. But as we've seen today, when the services PMI for January came in much stronger than expected, that has kind of encouraged kind of optimism that the UK economy could regain some upward momentum now that the negative kind of shock and uncertainty from the autumn budget is fading.

So that kind of stronger growth momentum, if that was to materialize at the start of this year, it could discourage some of the more hawkish MPC members from shifting in favor of a cut, perhaps as early as the March policy meeting. So the risk to our view that they'll cut rates in March, the risk is increasing that they could delay that at least until Q2, perhaps the May policy meeting. But the general direction still is that we still think rates are heading lower in the UK.

And for us, that's still part of our kind of rationale why we expect the pound to underperform compared to the euro this year. OK, so we should expect a gradual softening then? Yeah, gradual softening.

If the pound is to weaken more significantly, that's going to be driven more, I think, by kind of political fiscal risks in the UK. Certainly, as we've seen over the last 24 hours, there have been reports on the political side here in the UK indicating that that could be opening for Manchester Mayor Andy Burnham to become an MP here in the UK ahead of the local elections. And as we've been highlighting before, I think the local elections in May are probably the point of kind of maximum kind of danger for the pound, because if the Labour Party was to perform badly in those local elections, then the pressure would build on Prime Minister Starmer, who could then come under a leadership challenge.

So as we saw yesterday, the price action, the pound sold off sharply when the reports came through about Andy Burnham potentially seeing a path to becoming an MP. That's obviously important because for him to be in a leadership challenge, he needs to be an MP first and foremost. So yeah, he certainly, it's the market's reaction to that.

Pound sold off does highlight that, that that is a potential source of selling pressure for the pound as we move towards those local elections later this year. Okay, so that we have that support in May then. Definitely, that's certainly an area where we could certainly see more volatility in terms of pound performance this year.

Okay, well, thank you. Thank you for your time, Lee. Thank you, everyone, for listening.

I hope you all have a lovely weekend. Thank you for listening to this MUFG Global Markets podcast. Rate, review and subscribe.

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