MUFG said renewed Middle East conflict risk and rising oil prices are adding to upside pressure on the dollar, as higher energy costs feed inflation concerns at the Federal Reserve and tilt officials in a more hawkish direction. The bank added that market confidence in a near-term peace deal has weakened, though the pullback across financial markets has so far been limited.
The firm argued that a further deterioration in the region could push inflation risk higher and shift the balance of Federal Open Market Committee concerns away from growth and towards prices, with equities buoyed by AI-led optimism and the labour market remaining relatively stable. It also referenced remarks from Minneapolis Fed President Neel Kashkari that inflation is “much too high”, and from Chicago Fed President Austan Goolsbee that inflation has been above target for years and is moving in the wrong direction. MUFG said that, absent improved peace prospects, US yields could rise again, and strengthening yield spreads alongside tighter rate–FX correlations would favour further dollar gains.
Dollar Strength Amid Geopolitical and Inflation Concerns
Renewed conflict risks in the Middle East are reinforcing upside for the U.S. dollar, especially as Brent crude futures have surged past $98 a barrel this month. These higher energy costs are directly fueling inflation concerns at the Federal Reserve. We see this environment supporting further dollar strength if peace prospects do not improve quickly.
The confidence investors had in a quick resolution has been shaken, and inflation risks are building once again. The latest Consumer Price Index (CPI) reading for April came in hotter than expected at 3.8% year-over-year. This has led more Fed officials to express concern over inflation rather than growth, making a rate cut in the near term highly unlikely.
Market Strategies and Volatility Outlook
Given this, we are looking at buying call options on the U.S. dollar against currencies sensitive to higher energy prices, like the Japanese Yen and the Euro. Options on the USD/JPY with strike prices above 158 could offer favorable risk-reward in the coming weeks. This strategy allows for participation in dollar upside while capping potential losses.
We also anticipate a rise in currency market volatility, which has been relatively subdued. Looking at the playbook from similar geopolitical flare-ups in late 2022, buying straddles or strangles on major pairs like EUR/USD could be a prudent way to position for larger price swings. The VIX index, while equity-focused, has also ticked up to 17, suggesting broader market anxiety is growing.
The key driver for us is the renewed strength in the correlation between U.S. yields and the dollar. The 10-year U.S. Treasury yield has consequently pushed above 4.75%, widening the rate differential against other major economies. This makes long dollar positions, perhaps through futures contracts, increasingly attractive as long as this dynamic holds.
