Middle East risks continue to dictate FX fortunes

USD

The dollar reasserted itself on Tuesday after fresh US strikes on Iranian missile launch sites and mine-laying vessels in southern Iran unwound much of the cheer generated by President Trump's weekend Truth Social posts characterising negotiations with Tehran as "proceeding nicely". Brent rebounded toward $95/bbl from Monday's intraday low sub-$90 low, and the DXY nudged above 99 as flows turned defensive. May's Conference Board Consumer Confidence printed at 93.1 against a 92.0 consensus, though the Present Situation component slipped to 121.2, with respondents flagging the inflationary impact of the war. As we set out in our latest week ahead, Middle East headlines and the oil complex remain the primary catalyst for FX, overshadowing more conventional macro drivers. Today's docket is light, with Richmond Fed manufacturing and new home sales the main releases. The focal point of the week sits on Thursday — second estimate Q1 GDP, weekly jobless claims, and April core PCE all due. For the time being, however, the dollar is giving back some of yesterday’s gains, with markets continuing to digest recent Middle East developments. As was the case last week, this is seeing an initial risk-off tone give way to renewed peace deal hopes, leaving the dollar with little to prompt a breakout from recent ranges.

EUR

Early Tuesday trading saw EURUSD slip back modestly in the wake of overnight Iran strikes, before clawing back lost ground late in the session. The bloc remains acutely vulnerable to the energy shock, given its import dependence, with ECB chief economist Lane having already pre-positioned markets for the June staff projections to revise inflation higher and growth lower to reflect the war's macro fallout. Markets continue to price an ECB hike next month as close to a done deal, which sits in line with our base case. Today's calendar is quiet, with focus likely to shift to Friday's national CPI prints as the key data point for the bloc this week. While energy spillovers should keep the euro on a soft footing in the very near term, asymmetric relative rate expectations between a hike-leaning ECB and an on-hold Fed should increasingly cushion the downside in EURUSD, given current levels for the pair, as the June meeting comes into view.

GBP

Sterling extended its pullback on Tuesday with cable retreating from above 1.35 as UK markets reopened from Monday's Spring Bank Holiday into a firmer dollar following the renewed Iran flare-up. The move tallies with the cautious view we set out in our latest week ahead, which highlighted that the pound's recent performance looked vulnerable to a turn in the geopolitical narrative. Domestic political risk also remains an overhang: Labour's heavy losses in this month's local elections have left questions over Prime Minister Starmer's leadership unresolved, and long-dated gilt yields continue to trade uncomfortably high on fiscal concerns. The BoE held Bank Rate at 3.75% earlier in May on a hawkish vote split, and Governor Bailey's scheduled speech on Friday is likely the focal event for sterling this week, given an otherwise bare domestic calendar. We continue to think GBP will struggle to make sustained headway against the dollar while geopolitical risk premia remain elevated, with downside risks to cable from any further escalation.

CAD

Choppy, but ultimately directionless price action, remains the theme for USDCAD. Tuesday saw broad USD strength on the back of the Iran strikes, largely offset by a modest tailwind from firmer crude. As we have repeatedly flagged in recent morning reports, the loonie has struggled to extract durable benefit from elevated oil while safe-haven flows into the greenback dominate. At current levels, that leaves loonie performance more reactive than directional, with USDCAD contained to narrow ranges. Today's domestic calendar is bare, leaving the pair at the mercy of external drivers, with any further Middle East headlines and the US data run later this week the most likely catalysts. The standout domestic event comes on Friday with Q1 GDP, where consensus sits around 1.5% annualised — a sharp rebound from a 0.6% contraction in Q4, and broadly consistent with the Bank of Canada's April projections. We continue to expect the BoC to hold at 2.25% in June, with policymakers having explicitly left both cuts and hikes on the table, doing little to prompt a directional loonie move, provided that neutral guidance is maintained.

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