As tensions between the U.S. and Iran continue to escalate, oil prices are climbing steadily. Meanwhile, the U.S. equity market is largely brushing off geopolitical risks, removing any immediate need to sell off dollars. The cost of hedging currency fluctuations has dropped to December lows, and low volatility in the Forex market, combined with record-high equity indices, has created the perfect environment for the carry trade. Bears are actively capitalizing on this by shorting the euro against the dollar.
The interest rate gap between the Fed (which hiked to 2.25% in June) and the ECB remains substantial, playing right into the hands of carry traders. The European Central Bank is expected to hit pause in July: softer inflation in the eurozone and the escalating situation in the Middle East are prompting the regulator to pause and gather more data. This wide spread continues to weigh on EUR/USD, leaving the ECB’s signals regarding potential policy tightening in September as the European currency’s only hope for a reprieve.
However, this may not be enough to reverse the trend. The deaths of U.S. military personnel have triggered a new wave of airstrikes, and halting this escalation is becoming increasingly difficult. Brent crude has surged past $90 a barrel for the first time since early June. Rising commodity prices will inevitably stoke inflation. While the crude oil market has stabilizers like strategic reserve releases, the refined products market has no such safety nets. Furthermore, Ukrainian drone strikes on Russian refineries are acting as a powerful bullish driver for gasoline and diesel prices.
It appears that high inflation in the U.S. is here to stay for the long haul. This guarantees that interest rates will remain elevated and caps the dollar’s downside potential. But there is one important caveat.
If prices refuse to come down, you can always change the rules of the game. The U.S. Bureau of Labor Statistics (BLS) is revising its methodology for calculating the PCE index. They plan to remove or reduce the weight of asset management and software development services. As a result, when the August data is released in September, the headline PCE figure could come in 0.2 percentage points lower than current levels. Nevertheless, in the short term, the trajectory of EUR/USD will be driven far more by geopolitics, ECB policy decisions, and actual inflation dynamics.
