The rally in risk assets on ceasefire optimism came to a halt over the weekend. The ceasefire talks between the US and Iran collapsed in Pakistan and the US announced that the Strait of Hormuz will be blockaded to ships going to or from Iranian ports.
Markets are trying to sift through the whirlwind of headlines, but it appears that the US is weighing a resumption of limited strikes on Iran. So far, at least, markets are taking the news relatively well, as while oil prices have jumped, stock futures have fallen and the dollar rebounded, we have not seen a return to pre-ceasefire levels just yet. This suggests that investors perhaps see the breakdown in talks as more of a bump in the road and a sign of brinkmanship, rather than necessarily something that could derail the path to peace.
The collapse of the peace talks has, however, clearly thrown a wrench into markets. For one, headlines from the White House and military developments will remain the main market drivers. There isn't much in the economic calendar to draw the spotlight away from the war anyway. US producer prices for March, released on Tuesday, Eurozone industrial production for February on Wednesday and UK monthly GDP for February will provide further insight into the war's impact on activity and price pressures. With the prospect of renewed US strikes and the certainty of a blockade of Iranian ports, any expectations for the dollar to resume its downward trend will now be put on the back burner.
USD
US inflation spiked in March, as expected, due to massively higher gasoline prices, which increased the headline index nearly 1% in just one month. The core subindex behaved better, but the February PCE contradicted this bit of good news, showing a three-month annualised rate of nearly 5%. The producer price index for March, released on Tuesday, would not ordinarily garner much attention. However, as a key gauge of how the energy spike progresses through the production process we will pay close attention to this report.
Other data is indicating a so far quite limited impact of the war in the US economy, aside from the spike in gasoline prices, which is not that dramatic in historical terms. Market participants continue to believe that the Fed will look through these temporary spikes in headline inflation, although futures have again ruled out the possibility of any cuts this year following the collapse in peace talks. That could change very quickly, however, should we see any signs of a breakthrough before the end of the two-week ceasefire next Wednesday.
GBP
Domestic developments have taken a backseat to the war when explaining the performance of the pound. Ordinarily we'd be starting to worry about the May elections, the risk of a more expansionary fiscal policy, and a less business-friendly legislative background. News from the Iran war is overshadowing all else, however, and pressure on Prime Minister Starmer’s position has largely dissipated, at least for now.
The February data slate, due to be published this week, is too lagging to add to our understanding of the war's impact. Communications from Bank of England governor Bailey on Tuesday will carry far greater weight. We expect him to again push back against the prospect of an immediate hike, and given that the MPC was primed and ready to lower rates before the Iran war, we continue to find it difficult to grasp the idea of aggressive tightening this year, particularly should we see further de-escalation in the coming weeks. Aside from any surprises here, sterling will likely trade almost tick by tick with the common currency, driven predominantly by war headlines.
EUR
The defeat for Hungary’s Eurosceptic Prime Minister Victor Orban at the weekend’s elections should have provided at least mild support to the euro, as it removes a perennial obstacle to European Union policymaking. However, the collapse of the ceasefire talks shifts all attention back to the war. Notwithstanding the breakdown in talks, EUR/USD continues to trade just below the 1.17 level, which suggests to us that traders are still cautiously optimistic that cool heads will prevail, and that long-term peace remains more likely than not.
For now, we expect the common currency to be driven by two opposite factors. In its favor is the increasing hawkishness of ECB officials, which is closing the rate gap with the US dollar. Against it are the Eurozone's exposure to higher energy costs as a net-energy importer and the natural flight to the relative safety of the US dollar as long as the conflict lasts.
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