Markets are moving away from the view that inflation linked to the Middle East conflict will be short-lived. US longer-term inflation expectations, beyond a one-year horizon, have risen slowly but clearly since the end of April.
The US Dollar has gained support as US interest-rate expectations have increased. The Federal Reserve is often seen as acting earlier and more forcefully when inflation risks rise.
Fed Response And Dollar Support
During the 2022 energy shock, the Fed raised its policy rate in March, while the ECB waited until July. This earlier move is cited as a reason the Dollar can strengthen when inflation concerns grow.
The report notes that exchange rate returns depend on real interest rates, not nominal rates or the speed of rate rises alone. It adds that higher US inflation could reduce real returns even if nominal rates increase.
It also points to a risk that the Fed could turn more dovish. As a result, a strong and sustained Dollar rise is presented as uncertain.
We are seeing the market give up hope that the Middle East conflict is just a brief inflation shock. Longer-term US inflation expectations, like the 5-year, 5-year forward rate, have climbed to 2.7%, a noticeable increase since the start of the year. This shift suggests traders are preparing for stickier price pressures.
Options And Volatility Positioning
Our memories of the 2022 energy crisis are still fresh, when the Fed started hiking rates a full four months before the ECB. This history gives the US Federal Reserve a reputation for acting fast against inflation, which normally supports the dollar. Consequently, many traders are betting on a repeat performance, pushing up US interest-rate expectations.
However, we must be cautious about focusing only on how fast the Fed might act. With the latest US CPI print for April coming in hot at 3.8%, there’s a real chance inflation could outpace rate hikes. The profitability of a currency depends on its real interest rate, not just the headline number.
Given this uncertainty, we should consider buying long-dated call options on pairs like the EUR/USD. This strategy provides upside potential if the dollar’s strength fades, while capping our downside risk to the premium paid. It is a prudent way to position for a scenario where US inflation proves more stubborn than the Fed’s rate path.
We should also look at the price of currency volatility, which has remained relatively low despite these growing risks. Implied volatility on major dollar pairs may be under-pricing the potential for sharp moves around future inflation data releases and Fed meetings. Buying volatility through options could be a profitable trade in the coming weeks.
