Keep it secret: The dollar’s not safe

Since the US-Israeli war against Iran began on 28 February, stocks in the US, Europe, and Asia have plummeted, bond yields have jumped, and currencies across the world have tumbled – with one notable exception.

The US dollar index, which tracks the greenback against a basket of six major currencies, has risen by just under 3% since the end of last month. The dollar’s surge against the euro has been especially emphatic, at just below 3.5%.

Many saw this as evidence that markets were once again rushing to the safety of the world’s reserve currency. This was entirely typical before Donald Trump’s erratic trade policy, attacks on the Federal Reserve’s independence, and general volatility led investors to question the US financial system’s credibility.

If only it were that simple.

As Nicolas Véron, a senior fellow at Bruegel, a Brussels-based think tank, pointed out, the dollar’s appreciation is the predictable result of what economists call a ‘terms of trade shock’, in which a country or trading bloc faces a sudden change in import or export prices.

The US, a major oil and gas producer, has seen its currency surge as its export prices have risen, driven by the war’s negative impact on the world’s energy supply. Europe, conversely, is a net importer of fossil fuels, pushing the euro lower.

“The currency markets have reacted the way they should: the economies that experience a negative terms of trade shock see their currencies depreciate,” said Véron, who is also based at the Washington-based Peterson Institute for International Economics.

Carsten Brzeski, global head of macro at ING Research, said the dollar’s surge and Treasury sell-off reflect fears that higher inflation could cause the Federal Reserve to raise interest rates, and the fact that oil and gas are overwhelmingly priced in dollars.

It is not true that “all of a sudden, the dollar is back – at least not structurally,” Brzeski said. “The dollar is back due to oil prices.”

Véron also suggested that the media coverage – especially in the US – is largely driven by a refusal to recognise the irreparable harm Trump has inflicted on America’s financial reputation. “Many people in the US would like to be reassured that the dollar remains at the centre of the world,” he said.

All at sea

But where, exactly, can investors safely park their cash if not in the US?

“Nothing is safe right now. We’re all on the high seas,” Véron said.

Yet this absence of a global financial haven might also have a silver lining.

Widespread fears about America’s financial credibility, and soaring US borrowing costs in particular, led Trump to suspend his sweeping ‘Liberation Day’ tariffs barely a week after introducing them last April. (The bond market was acting “a little bit yippy”, as he put it at the time.)

Could the surge in US Treasury yields – and the war’s broader economic fallout – force Trump to end the war sooner rather than later?

Sander Tordoir, chief economist at the Centre for European Reform, thinks that it might.

“The longer the war drags on, the higher the political cost for the president: rising petrol prices at the pump, financial market volatility, higher US borrowing costs, and damage to US allies in the Gulf,” Tordoir said. “Trump needs an off-ramp, and he needs it fast.”

However, analysts also warn that the current situation differs from Liberation Day in several critical – and potentially worrying – ways.

First, the current yield on 10-year US Treasuries is just under 4.3%, well below the 4.6% peak witnessed in the aftermath of Liberation Day. Second, April’s spike was driven largely by investors diversifying away from dollar-denominated assets, while today’s US debt sell-off is mostly due to fears of an inflationary resurgence.

Third, and most crucially, Trump now isn’t the only one calling the shots.

“Unlike with tariffs, [which] the US can impose or retract unilaterally, Trump needs other actors, most notably Iran itself, to go along with the off-ramp,” Tordoir said.

Brzeski, meanwhile, suggested that the aftermath of Liberation Day “almost looks like kindergarten” compared to the present crisis.

Last April, “Trump was holding all the cards,” he said. “But the current situation is riskier and more dangerous.”

Like the millions of people in the Middle East, financial markets might not just have no place to hide. They might be plunging inexorably into the abyss.

Economy news roundup

Europe chides US for easing Russian oil sanctions. European leaders rebuked the United States’ decision to lift sanctions on Russian oil exports on Friday, as the war in the Middle East continued to wreak havoc in global energy markets. “We believe that easing sanctions now, for whatever reason, is the wrong thing to do,” said German Chancellor Friedrich Merz. European Council President António Costa also criticised the move. “The unilateral decision by the US to lift sanctions on Russian oil exports is very concerning, as it impacts European security,” he wrote on social media. Read more.

Iran war could trigger ‘substantial stagflationary shock’, warns EU economy chief. Valdis Dombrovskis said on Monday that a “protracted” war risks triggering supply chain disruptions and “negative confidence effects” that would cause prices to surge and output to weaken – a scenario reminiscent of the one Europe experienced after the Yom Kippur War between Arab states and Israel in 1973. Read more.

EU pushes back on US ‘overcapacity’ probe amid trade deal uncertainty. European Commission Deputy Spokesperson Olof Gill said on Thursday that China – but not the EU – is ultimately responsible for the “global distortions” that have flooded world markets with cheap industrial products. His comments came after Washington announced so-called Section 301 probes of multiple American trading partners, including the EU, for alleged “structural excess capacity and production in manufacturing sectors”, as the US scrambles to reimpose tariffs that were struck down by the Supreme Court last month. Read more.

(mm, mk)