Historical precedent suggests that in a positive growth environment, a geopolitical shock like a potential US-Iran conflict might not lead to a sustained risk-off rally in the US dollar. Markets may price out the risk premium quickly, allowing pro-cyclical trends to resume, as seen in a similar event last year.
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Contrary to typical risk-off behavior, a financial shock originating in the US would likely be positive for the EUR/USD exchange rate. This is because it creates more room for the US Federal Reserve to reprice its policy downwards and can trigger repatriation flows out of US equities.
While the idea of US growth re-acceleration is driving dollar strength, it's not the only story. Recent positive surprises in European PMI data and upgraded Chinese GDP forecasts suggest broader global growth resilience. This breadth should help cap the US dollar's rally and may promote weakness against other currencies.
Protests in Iran, if they disrupt the regime, could halt cheap oil flows to China. This would force China to buy from more expensive, US-friendly markets, strengthening the US dollar's global dominance and isolating anti-Western powers without direct US intervention.
While a major sell-off in AI stocks would likely cause an initial "knee-jerk" strengthening of the US dollar due to risk aversion, the subsequent focus would shift to the US's twin deficits, leading to a multi-year dollar weakening trend once volatility subsides.
Contrary to the historical norm where volatility rises with a strengthening dollar (risk-off), the market is now experiencing higher volatility as the dollar falls. This unusual 'dollar down, vol up' dynamic suggests a pro-cyclical market backdrop and has major ramifications for how FX options and risk reversals are priced.
A series of upcoming US policy events, including Fed appointments and defense spending debates, are collectively skewed towards dovish monetary policy implications and a weaker fiscal picture. This creates a coordinated downside risk profile for the US dollar, suggesting potential for weakness is greater than for strength.
Despite alarming geopolitical headlines concerning Venezuela, Iran, and US-NATO relations, emerging markets are showing resilience. Investors are largely ignoring this "noise," focusing on the strong cyclical backdrop: upward growth revisions, loose financial conditions, and supportive commodity prices. Markets are prioritizing the global economic outlook over political shocks unless those shocks directly threaten growth.
The classic "stocks down, dollar up" correlation is weakening. A J.P. Morgan model shows that relative US equity underperformance (dollar-negative) is currently offsetting the effect of an outright global equity decline (dollar-positive). This dynamic leads to only modest moves in the dollar despite stock market stress.
Despite investor fears fueled by geopolitics and rising gold prices, key market indicators—inflation expectations, rate volatility, USD valuation, and credit spreads—show surprising stability. This suggests the underlying economic foundation is stronger than negative sentiment implies, supporting a positive market outlook for now.
The U.S. Dollar's value has been driven less by conventional factors like growth expectations and more by an unconventional "risk premium." This premium reflects market reactions to policy uncertainty, such as talk of FX intervention or tariffs. This has caused the dollar to weaken far more than interest rate differentials alone would suggest, creating a significant valuation gap.