The ongoing closure of the Strait of Hormuz, following seven turbulent weeks of war, has amplified global economic uncertainty, with a new analysis suggesting that central bank actions—particularly in the short term—will dictate the immediate winners and losers in the foreign exchange markets.
Thu Lan Nguyen, head of FX and commodity research at Commerzbank AG, distinguishes between the short and longer term for currency market development.
“In the short term – and we have already seen this to some extent – the focus is likely to be very much on the immediate reactions of the central banks. Which central banks react fastest and most aggressively (with rate hikes) to the inflation shock? Their currencies are likely to benefit,” Nguyen stated.
This dynamic was evident in 2022, when the US dollar benefited from the Federal Reserve’s early and rapid rate hikes, while the euro, British pound, and Swedish krona lagged due to more hesitant responses from their respective central banks.
Short-term central bank action vs. long-term inflation control
This time, however, the euro and the British pound are showing greater resilience against the dollar.
This suggests “markets trust both the ECB and the Bank of England to have learned from the mistakes of four years ago and to react early to inflation risks,” according to Nguyen.
The Swedish krona, conversely, is weakening as the Riksbank “is once again proving hesitant.” Despite this, Nguyen expressed caution:
We have already expressed our doubts about market expectations for the ECB on several occasions, which is why we see the further upside potential in EUR-USD as limited. But that is only the short-term view.
The longer-term perspective shifts the focus from the speed of rate hikes to success in controlling inflation.
“In the longer term, it is not about which central bank raised rates how quickly or how sharply, but which has successfully brought inflation under control,” Nguyen explained.
Looking at recent history, while core inflation has fallen across the US, UK, euro area, and Sweden, it has most recently remained above target in the UK and the US.
In the euro area, it was only slightly above the 2% target, and in Sweden, it has fallen below 1%. This, alongside political developments, “helps explain why the euro and the Swedish krona were able to perform significantly better than the dollar and the pound over the past year.”
Greatest risks seen for the US dollar
Looking ahead, Nguyen believes “the wheat is likely to be separated from the chaff, and only those currencies will prove robust where inflation falls back towards the 2% target more quickly.”
The greatest concerns are directed towards the US dollar.
“We see substantial risks in particular for the dollar,” Nguyen asserted.
Nguyen highlighted that beyond recent firmer inflation due to significant increases in import tariffs.
“Apart from inflation, which has recently been firmer anyway due to the significant increases in import tariffs, further attacks by the US government are likely to make it difficult for the US central bank to respond adequately to an inflation shock,” she said.
This is therefore where the greatest inflation concerns could emerge in the market at a later stage.
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