- The Federal Reserve can keep rates high, while the ECB is unlikely to raise them.
- The Japanese economy has taken a double hit and needs further stimulus measures.
It fell sharply after Donald Trump said the Middle East conflict is coming to an end. If it had continued, oil prices could have skyrocketed to $150 per barrel, a severe blow to the economies of oil-importing countries. The United States, with its strategic reserves of 415 million barrels and active drilling, would be able to withstand the energy shock, but Europe would not, so the latest turnaround was a relief for the battered EURUSD.
The resilience of the US economy could allow the Federal Reserve to keep interest rates high despite a possible acceleration in inflation. The futures market has increased the probability that the federal funds rate will remain unchanged through the end of 2026 to 18% from 8% before the Middle East conflict. Investors now anticipate one period of monetary easing instead of two as previously expected.
Derivatives in Europe indicate a growing possibility of the ECB tightening monetary policy. In reality, the European Central Bank will be constrained if the eurozone goes into recession due to excessively high oil prices. Even if the conflict ends soon, restoring oil production will be a challenge. There is a market view that prices will not return to pre-war levels until the end of 2026.
Rising oil prices, combined with a weak yen, represent a double blow to the Japanese economy, increasing the risk of stagflation. The rate is rising because, if confrontation in the Middle East persists, the Japanese Prime Minister will need to prepare a new set of fiscal support measures. This will further weaken the yen.
If Donald Trump's statement about an imminent peace deal had not caused the US dollar to fall, one could have assumed that the drop in USDJPY was due to currency intervention. In the past, when the pair approached 160, this triggered active measures by market authorities.
The decline in the US dollar has helped gold recover. According to Bloomberg, holdings of gold-focused ETFs fell 30 tons over the past week, marking the steepest drop in two years.
He FxPro Analyst team
