Will geopolitical conflicts spillover into currency tensions?

Once again, geopolitical risk has come to the fore as Israel and Iran launch attacks on one another, to add to Israel’s incursion into Gaza following the October 7^th attacks last year on Israel by Hamas. All this is on top of the war in Ukraine that continues to rage on. The currency market seems to be taking it all in its stride.

Should currencies be impacted when conflict breaks out? Clearly countries that are directly involved in any war will likely see their currencies move. But what about the currencies of countries that are not directly involved? The most obvious connotation is a rise in demand for so-called safe assets, including safe currencies such as the US dollar, the yen and the Swiss franc.

However, Steve Barrow, Head of Standard Bank G10 Strategy, said any strength here is likely to be very temporary; it reflects the knee-jerk reaction of currency traders who try to profit from ‘predictable’ currency movements, such as rallies in these safe-asset currencies whenever a conflict breaks out. For longer-term traders and investors, such safe-asset considerations by themselves are unlikely to represent a compulsive reason to hold these safe currencies for the long haul.

Wars can break out quickly, but they can end quickly too, and, even when they do last some time, as we’ve seen with Ukraine, the impact on currencies is subject to a rapid diminishing of marginal returns, which, in plain English, means that traders and investors get so used to the ongoing conflict that it no longer has the capacity to move the market. The bottom line is that wars and conflicts, per se, don’t bring significant and long-lasting currency movement, even in the alleged safe-haven currencies.

However, this is not to say that we should ignore them. For a start, conflicts do not bring lasting currency movement per se. What we mean by this is that the outbreak of a conflict is not enough, in itself, to produce a significant and sustainable currency moment. If the war has clearly identifiable discrepant implications for different countries, then it seems reasonable that currencies should move; not just in the short-term but over the long haul as well.

The best example of this is the war in Ukraine, as the early stages of this brought about huge increases in energy prices for Russian-dependent countries in Europe, relative to the far more minor impact we saw in energy-rich countries, such as the US.

In other words, the war created a huge deterioration in Europe’s terms of trade (the ratio of export prices to import prices) relative to the US – and that’s usually a recipe for US dollar strength. This was proved as the US dollar went on a 6-month surge against the euro, rising some 15% after the war started. Its gains against a, similarly vulnerable, pound were an even bigger 20%.

In fact, it was only last month that the pound reached the levels seen just before the war broke out, while the euro has never recaptured these pre-February 24^th 2022 levels. This shows that wars can have considerable currency connotations, even if the countries experiencing weakness and strength are not directly involved in the conflict.

The question now is whether tension in the Middle East could create similarly disruptive and discrepant upset for energy importers, like Europe, relative to energy-rich countries such as the US. This is a question that could be answered very soon should Israel successfully damage Iranian energy facilities in any retaliatory attack.

Steve Barrow’s suspicion, though, is that it will be answered in the negative. This is not because he doubts Israel’s ability to cause significant damage, but because he does not anticipate the same sort of huge terms of trade discrepancies that we saw when Russia attacked Ukraine, not least because Russia supplied a significant part of Europe’s energy needs at the time, and that’s clearly not true in the case of Iran now. Of course, none of this rules out a slump in the likes of the euro or the pound against the US dollar should Israel strike and energy prices surge. But he suspects this will be temporary, not long-lasting.