US and Israeli interventions against Iran have led to a significant revaluation in the currency market. Since the first attacks were launched, the US dollar has gained about 1.5% on a trade-weighted basis, with most currencies declining against the dollar. Emerging market currencies have been particularly affected, with the Korean won losing over 3%. Most notably, the attacks have caused a significant increase in oil and gas prices, suggesting that recent currency dynamics largely reflect movements in the commodity sector.
Given the possibility of a prolonged war in the Middle East, it is useful to examine the relationship between oil and foreign currencies. There are considerable differences in how currencies react to rising oil prices. However, classifying them into three main groups seems to be the most practical approach.
Currencies of crude oil exporting countries, such as the Canadian dollar and the Norwegian krone, tend to benefit from rising oil prices. The Australian dollar also tends to gain ground, given Australia’s importance as the world’s second-largest LNG exporter. In the emerging market currency landscape, Latin American currencies usually hold up best. However, the positive impact on the currency market of a rise in oil prices can occasionally be offset by other factors, as demonstrated by the case of Norway.
Conversely, rising oil and gas prices tend to weigh on the currencies of net energy importing countries. Among G10 currencies, the euro and the Japanese yen tend to be the most sensitive. For both currency areas, higher energy prices represent a negative shock to terms of trade that reduces real national income. Indeed, the deterioration in commodity terms of trade was one of the key factors behind the euro’s weakness in 2022, when Europe experienced a severe energy crisis at the start of the war in Ukraine. Within the net energy importers group, emerging market currencies are usually the hardest hit. Emerging economies tend to have higher energy intensity (units of energy consumption per unit of GDP) and thus suffer more severe terms of trade shocks. Asian and Eastern European currencies stand out in this regard. Capital outflows to safe-haven assets can put further pressure on emerging market currencies.
Safe-haven currencies constitute a third, albeit smaller, group. As with most net energy importing countries, rising energy prices weigh on the Swiss economy. However, the Swiss franc often appreciates during periods when rising energy prices are due to increased geopolitical uncertainty. (As a side note, the appreciation of the Swiss franc substantially offsets part of the rise in oil prices, easing upward pressure on Swiss inflation). The same applies to the US dollar, which has historically shown an inverse relationship with oil. Although the dollar-oil correlation was inverse in the years following the global financial crisis, this relationship weakened considerably after 2019 and recently turned positive, likely reflecting the fact that the US economy achieved energy self-sufficiency in the late 2010s. In recent years, the US has even become a net energy exporter.
Finally, it is useful to take a look at risk reversals. Although currency markets may appear calm on the surface, implied volatilities in options reveal market expectations regarding short-term currency moves. Indeed, 3-month risk reversals on the US dollar indicate fears of a prolonged period of high energy prices. Market implied expectations have undergone a more significant adjustment for EUR-USD, where the positive skew has turned negative, suggesting that, among G10 currencies, the euro is set to benefit most from a significant de-escalation.
