Over the last week, 16 central banks held policy decision meetings, including major ones like the Fed, ECB, and BOE. While the vast majority kept interest rates unchanged, the tone and outlook they gave generated a sea change in perceptions of monetary policy. This is crucial for forex traders, since monetary policy is the primary driver of currencies worldwide.
The general impression among markets was a significant shift towards hawkishness ahead of expected inflationary pressure from higher crude prices resulting from the war in the Middle East. This is unlike the last time, when central bankers were caught flatfooted by the war in Ukraine, saying that consumer cost increases would be transitory. Policymakers seem poised to correct that mistake by being particularly eager to hike this time around. But that could also be a different kind of mistake, and markets could react quickly to the rapidly evolving war situation.
Most Countries Face Higher Price Pressure
The dollar retraced this week due to a shift in market perceptions of global interest rates. The Fed was more hawkish than before, reducing its projections of a rate cut this year. But the BOE and ECB went further, directly addressing the potential price shock of higher energy prices. Which makes sense, since Europe is much more exposed than America is to the effects of the war in the Middle East.
The price differential between WTI and Brent has widened substantially, reaching as much as $20 at certain points during the week. This reflects the difference between the US being a net crude supplier and ramping up production, and Europe being a net importer and unable to secure increased supply from the Middle East. Asia is facing an even more acute situation, given its higher reliance on imports from the Persian Gulf. The majority of Europe’s petroleum and natural gas imports come from the US.
How Many More Hikes?
The US is expected to see a much smaller price impact as a result of the war than Europe and Asia. One particular point of note is that the US does import refined fuel from Europe, particularly diesel. This is a result of the US not building refineries in the last few decades. Despite being an overall petroleum exporter, the US has to import certain fuel blends, which could increase prices in certain areas. However, the vast majority of energy production in the US does not rely on imports but rather on long-term contracts, which could leave consumers largely unaffected if the oil disruption ends within a matter of months.
As a result, markets do not expect the Fed to hike this year. This contrasts with the BOE and ECB, which are both expected to hike by at least 50 bps by December. They could hike as soon as April, depending on how prices react this month. The ECB’s particularly strong wording left the dollar index lower, as the Euro is by far the largest component. Markets were already pricing in higher rates from the BOJ. But other countries also added to the downward pressure on the dollar, as central banks such as Denmark and Czechia are pegged to the Euro and would likely hike if the ECB did.
Will the Trend Last?
However, markets might have gone overboard in expecting higher rates, something that even BOE Governor Andrew Bailey pointed out after the rate decision. The current outlook for monetary policy is highly dependent on crude prices staying elevated. Meanwhile, the White House has been taking numerous measures to reduce supply-side shocks, such as lifting restrictions on Russian and even Iranian oil imports. US and Israeli mentions of a scaling back of attacks on Thursday caused a major retracement in crude prices right after most of the major central banks held their meetings.
An end to the war, or a mechanism that would allow the reopening of the Strait of Hormuz, could cause crude prices to crash and reverse all the recent moves in the market. That measure would be largely political rather than data-driven, making the timing (or even the possibility) hard to predict. Markets are pricing in a total closure of the Strait, but there is ample evidence that crude is being rerouted (though at risk) or is being allowed passage directly. Once their is more clarity on the actual supply and demand balance, markets might have to adjust.
