Commerzbank’s Thu Lan Nguyen notes that markets are shifting towards a scenario of a lasting inflation shock linked to the Middle East conflict, pushing US inflation expectations higher. She highlights the Dollar’s traditional support from the Federal Reserve’s proactive reputation but warns that real interest rates and relative inflation paths matter. Nguyen remains cautious on a strong Dollar appreciation given potential higher US inflation and a more dovish Fed.

Lingering energy shock supports Dollar cautiously

"The market is increasingly abandoning the hope that, with regard to the Middle East conflict, we are merely dealing with a short-lived inflation shock. This can be seen, for example, in longer-term inflation expectations – that is, those looking beyond a one-year horizon. In the US, for instance, these have been slowly but noticeably climbing since the end of April."

"My colleagues have also explained in recent days why the dollar is benefiting in this environment: namely the sharp rise in US interest-rate expectations. Indeed, the US Federal Reserve enjoys a reputation as an active central bank – one that reacts very early and sufficiently strongly to inflation risks – which is why the dollar tends to benefit in times of rising inflation. And memories of the last energy crisis in 2022 are still fresh: back then, the Fed raised its policy rate as early as March, whereas the ECB waited until July."

"However, I would be cautious about relying solely on the speed at which central banks react. At first glance, that may seem logical: where interest rates rise the fastest, the currency’s carry also increases the fastest. But the profitability of a currency depends not on the nominal interest rate, but on the real interest rate."

"For the time being, I would therefore be cautious about betting on a pronounced appreciation of the dollar - because of potential higher US inflation pressure, and because of the risk of a more dovish Fed."

(This article was created with the help of an Artificial Intelligence tool and reviewed by an editor.)