Why the US-Iran Truce Has Not Helped the Euro
Lower oil prices and hopes of a ceasefire should have supported Europe’s currency, but US rates, fiscal expansion and safe-haven flows continue to favour the dollar. A commentary by Lorenzo Bini Smaghi
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The conflict with Iran has not weakened the dollar’s role as an international reserve currency. On the contrary, as has often happened in the past, the US currency tends to strengthen on foreign exchange markets whenever international tensions intensify. Its role as a safe asset has also emerged when the United States itself has been the source of geopolitical instability.
Immediately after the outbreak of the latest conflict in the Middle East, the dollar appreciated against the main currencies, especially the euro, gaining about 4 per cent in the first two weeks. The European currency then recovered as expectations strengthened that the conflict would soon end, or at least that a truce would be reached.
Several observers expected the ceasefire agreement of mid-June between the United States and Iran to ease the upward pressure on the dollar and support an appreciation of the European currency. This seemed all the more likely as oil prices returned to their pre-conflict levels, reducing the recessionary impact on European economies.
These expectations, however, have not materialised. On the contrary, the euro has weakened further against the dollar, reaching its lowest level in the past year, at around $1.14.
Several factors, both in Europe and in the United States, may have changed the currency outlook.
Starting on the other side of the Atlantic, the Federal Reserve’s first meeting disproved expectations that US monetary policy would become more accommodative after the appointment of the new Chair, despite the pressure that President Trump will certainly exert. There is no room for a cut in interest rates if inflation is to be brought back to 2 per cent over the medium term.
The US economy remains resilient, above all as a result of strongly expansionary fiscal policy.
The International Monetary Fund estimates the public deficit at 7.5 per cent of gross domestic product this year and next. The president has asked Congress for a further increase in spending to finance the conflict and rebuild ammunition stocks, which have fallen to a low level.
US fiscal policy will certainly remain expansionary in the coming years, at least until the next presidential election in 2028. This makes a reduction in interest rates rather difficult.
The US currency also continues to benefit from inflows of foreign capital, to finance large investments in technology and artificial intelligence, supporting equity valuations.
On the European side, the fall in oil prices should contain the risk of imported inflation and prevent second-round effects on the costs of other products. Growth prospects, however, remain uncertain. The impact of rising imports from China on the competitiveness of European industry is becoming increasingly evident. The combination of these factors could lead the European Central Bank to postpone, or even cancel, the second rate hike expected for September.
In this context, it is hard to see the short-term interest rate gap between the two sides of the Atlantic, currently around 1.4 percentage points, narrowing. Speculative investment strategies, or carry trades, which encourage borrowing in the currency with lower rates, the euro, and investing in the currency with higher rates, the dollar, tend to strengthen the US currency.
Another factor supporting the dollar concerns the negotiations under way during the truce between the United States and Iran. Experience with similar talks suggests that the most likely outcome is a repeated extension of the truce, possibly with temporary interruptions, given the complexity of the issues to be resolved and the different negotiating strategies. Uncertainty will prevail for a long time before the two sides reach a stable agreement and tensions are definitively reduced.
Finally, the approach of the US elections in November, and the high probability that the House of Representatives will be controlled by the Democratic party, put at 80 per cent by the latest poll, while the situation in the Senate remains highly uncertain, with Democratic control put at 43 per cent, point to a possible shift over the next two years from the policies pursued so far by the administration, which had directly or indirectly favoured a weakening of the dollar.
This last assumption, however, rests on the expectation that the White House will accept, without demur, not only the result of the ballot box but also being placed under restraint by the new Congress. A rather optimistic assumption, undoubtedly.
A previous version of this article was published in the Italian daily Il Foglio
IEP@BU does not express opinions of its own. The opinions expressed in this publication are those of the authors. Any errors or omissions are the responsibility of the authors.
