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(Bloomberg) — Betting on continued US dollar strength is the cleanest way for foreign-exchange traders to take a position on a new regime of higher rates and inflation, according to BMO Capital Markets.
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Traders in the $9.5 trillion-a-day foreign exchange market are “too eager” to price in the US-Iran war resolution, Mark McCormick, BMO’s chief FX strategist, wrote in a note on Monday. Oil prices may retreat after the conflict ends, but the inflationary effects will linger, fueling higher rates globally and slower economic growth, which favors the US currency, he said.
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“Even if oil retreats at the margin — a big if — inflation is unlikely to fall as quickly; second-round effects are building, and correlations are shifting in ways that increasingly favor higher rates and a stronger dollar over headline optimism,” McCormick said.
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BMO is staying broadly long on the dollar, especially against the euro, British pound and yen. McMormick’s team also expects the dollar to strengthen against the Australian and Canadian dollars.
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A dollar gauge advanced about 2% since the US and Israel started bombing Iran in late February. Though the war has upended global energy flows and hurt oil importing countries, the US has weathered the higher energy prices and reported strong economic data. Traders have fully priced in a Federal Reserve interest-rate hike by the end of this year after May US job growth topped all forecasts.
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The Bloomberg Dollar Spot Index had the best day in more than two months on Friday after the jobs report, and US two-year yields, which are most sensitive to changes in US central bank expectations, had the biggest one-day rise since President Donald Trump levied tariffs on most of the US’s trading partners in April last year.
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The index edged lower on Monday after posting 1.1% gains in the week prior.
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Consumer prices have been accelerating globally and in the US. Euro-area inflation topped 3% for the first time since 2023 in May, cementing a case for rate hikes, eventhough the region’s economy is struggling.
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The US will issue May’s inflation data on Wednesday, and the median estimate for the annual rate is for an increase of 4.2% in May, up from 3.8% in the previous month.
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“We think higher rates, weaker growth, and wider macro dispersion remain the more durable story — and that should continue to favor the dollar, and the outperformance of US assets, in this evolving regime,” he said. “Headlines are noise; regime is the signal.”
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What Bloomberg strategists say…
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“Fed rate-hike bets look stickier given the US economy’s resilience in the face of elevated crude prices. That’s supporting expectations for a higher neutral rate and rising inflation in the months ahead, which will help the dollar shake off its geopolitical hangover.”
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— Tatiana Darie, Macro Strategist, Markets Live. For the full analysis, click here.
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