Contrarian Signal

The macro point

Much has been said about the military conflict in the Middle East and its impact on financial markets, including Forex. Many things are false. One example: the Japanese yen is the best hedge against the rise of geopolitical risk, as stated by a major Nordic investment bank. This is often the case. But not always. In the current situation, the Japanese currency has continued its long-standing depreciation against the euro. How can this be explained? The ongoing military conflict, as tragic as it is, should result in primarily regional repercussions. Furthermore, traders are skeptical about the prospect of an imminent rate hike by the Bank of Japan, which has been postponed several times this year. This may have also penalized the Japanese currency.

Let's take a step back. The benchmark study by Guidolin and La Ferrara, published in 2010, analyzes 28 international conflicts and their impact on the MSCI World stock index (which is the broadest possible). The results are clear. Two triggered a significant negative reaction in stocks, while three, including the Iraq war in 2003, resulted in a rise in stocks. In the vast majority of cases, military conflicts had a near-zero effect on stocks. They are non-events, widely commented on, but without lasting consequences on the stock markets.

The same observation applies to the foreign exchange market. Geopolitical risk can cause sudden and ephemeral price spikes – usually benefiting safe-haven currencies (US dollar, Swiss franc, Japanese yen). But this is not invariably the case. Even currencies directly affected by the conflict can withstand fairly well. Witness the Israeli shekel, which is down only -1.20% over the past week. Considering the situation on the ground, that's little. One might also think that the Canadian dollar, due to its close correlation with the price of oil, would have benefited from the surge in energy prices. On the contrary, the EUR/CAD pair is up +0.62% over the past five sessions.

The moral of all this is to be wary of the simplifications often heard here and there. For a company looking to hedge its exchange rate risk without being directly exposed to the country or countries in tension, geopolitical risk is probably not the primary factor to consider. Monetary policy, capital flows, and the evolution of the trade balance are much more important because they often have lasting effects. Remember, for example, that the sharp rise in the euro in the first quarter was mainly due to incoming capital flows in the eurozone to invest in undervalued European stocks. The amounts were so substantial that they structurally supported the exchange rate of the single currency for several consecutive months.

Technical point

In the foreign exchange market, distrust towards the dollar remains abnormally high. Asset managers have never been so negative about the greenback in twenty years, according to data from the US regulator. In France, many investment banks now expect the EUR/USD pair to reach 1.20 or even beyond. It's not unreasonable. This is the 16th time since 1973 that the Dollar Index (which measures the dollar's movement against the currencies of major trading partners) has dropped more than 10% in the space of five months. Historically, this has led to a strong rebound. Will this happen this time? Not certain. In any case, probably not right away. There are still too many uncertainties about US trade policy, rumors of unilateral devaluation of the greenback. We still anticipate a -7% drop in the Dollar Index by the end of the year.

However, the dollar's depreciation is not occurring against all currencies. For instance, the Vietnamese dong reached a new historic low against the American currency last week.

Announcements to follow

The agenda is mainly American this week, with consumer confidence for June expected to remain well-oriented. Regarding inflation, the Federal Reserve, which kept its rates unchanged last week, is expected to closely watch the core PCE index for May. It is expected to continue falling, which confirms that there is no need to change rates immediately. Overall, contrary to the fears stated in April following 'Liberation Day,' the US economy is in rather good shape.

Below are the publications and events expected to have a major impact on currency rate developments.

The information presented in this publication is provided for informational purposes only and does not constitute investment advice, an offer to sell, or a solicitation to buy, and should not be used as the basis or considered as an incitement to engage in any investment whatsoever.