The Fed could do what the ECB can’t

The Fed could do what the ECB can’t

·         The Fed may keep rates high, while the ECB is unlikely to raise them.

·         Japan's economy has been hit by a double blow and needs new stimulus measures.

The US dollar fell sharply after Donald Trump said the Middle East conflict is nearing its end. If it had dragged on, oil prices could have soared to $150 per barrel, a serious blow to the economies of oil-importing countries. The US, 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 turn was a relief for the battered EURUSD.

The resilience of the US economy could allow the Fed to keep interest rates high despite a potential acceleration in inflation. The futures market has increased the likelihood of the federal funds rate remaining unchanged until the end of 2026 to 18% from 8% before the conflict in the Middle East. Investors now anticipate one period of monetary easing rather than two as previously expected.

Derivatives in Europe indicate a rising chance of the ECB tightening monetary policy. In reality, the European Central Bank will be constrained if the eurozone enters a recession due to excessively high oil prices. Even if the conflict concludes soon, restoring oil production will be challenging. There is a market view that prices will not revert to pre-war levels until the end of 2026.

The rise in oil prices, combined with a weak yen, presents a double blow to the Japanese economy, ballooning the risk of stagflation. The USDJPY rate is climbing because, if the Middle East confrontation 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 might have assumed the USDJPY decline was due to currency intervention. In the past, when the pair approached 160, it triggered active measures by market authorities.

The US dollar's retreat has helped gold recover. According to Bloomberg, gold-focused ETF holdings fell by 30 tonnes over the past week, marking the sharpest decline in two years.

By the FxPro Analyst Team