Iran war fatigue and the Burnham wildcard

Despite some encouraging signs of progress, the Iran war continues to drag on without a clear end in sight. Investors are exhibiting an element of headline fatigue, as the sort of headlines that would have previously been greeted with wild gyrations in markets are now being either roundly ignored or treated with caution. EUR/USD has subsequently traded within a tight range - we discuss what could trigger a breakout. 

This month is also a big month in the UK. The Bank of England looks set to hold policy steady, but the real focus will be on the Makerfield by-election. A victory for Greater Manchester mayor Andy Burnham could clear his path to Number 10. But what does this mean for the pound and gilts?

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Transcript

June’s Big Macro Scoreboard

SPEAKER_00 0:00

Welcome back to FX Talk and Ebry Podcast, all about the foreign exchange market. My name is Matthew Ryan. I'm joined as usual by Chief Economist Enrique Diaz Alvarez. Investors could be forgiven for having half an eye on the sports pages this month. The 2026 FIFA World Cup is finally here, bringing the usual mix of drama, upsets, and questionable refereeing decisions. But financial markets are set to serve up a spectacle of their own in June. Most of the world's major central banks will be lacing up their boots for pivotal central bank meetings, headlined by a managerial debut of the Federal Reserve. Iran World peace talks are also heading deep into extra time. Those signs of progress means that we could potentially see news of a framework deal being signed as soon as this month. And in the UK, pressure on Prime Minister Keir Starmer looks set to intensify should Greater Manchester Mayor Andy Burnham triumph at the maker field by-election, which would put him firmly through on go for the Labour leadership. Football pun's out of the way last month saw a broad recovery in risk appetite as markets opted to take a glass half-full view on the latest Iran war headlines. Equity markets have been trading as if the conflict never even happened. The safe haven dollar has lost ground against most of its major peers. Bond yields have retreated amid easing concerns over runaway inflation and aggressive tightening cycles. And oil, while still carrying a meaningful Iran war risk premium, has also retreated fairly markedly. So lots going on. Let's go straight

Risk Rally Despite Middle East War

SPEAKER_00 1:39

into it. First up, I wanted to talk about Eurodollar because the world's major currency pair has been trading in a remarkably tight range in recent weeks, and volatility in the pair is has dropped off. One month implied volatility in Eurodollar is now at its lowest level since January, and six-month implied volatility has fallen to around its lowest level since 2021. On the face of it, that seems quite strange. We've got an active war in the Middle East, a pivotal central bank meetings coming up, a new chair at the FMC. So why has the pair gone to sleep? I think there's a a few things worth unpacking here. The first question is whether we're simply seeing an element of Iran war headline fatigue. Recent news stories that at the beginning of the war would have been greeted by wildans in currencies are now either being roundly ignored or treated with the utmost caution. Enrique, would you agree? Are markets increasingly now desensitized to the conflict, or is there something else at play?

SPEAKER_01 2:51

Yeah, no, it's just it's it's really eerie. Like the uh cheat and currencies are moving in very tight, at least the major ones are moving in very tight uh ranges versus with respect to each other. Um oil prices remain for now uh tame, relatively tame as as reserves are being drawn um so that no major disruption is emerging from the closure of the street of Hormuz. Uh and the one constant that we have is uh first record highs in the US stock market. It's it's a very, like I said, it's it's a strange state of affairs. Um that uh on the one hand, the the one call I would make that is it's notable to see risk appetite again as seen by the record highs that we hit almost weekly in the US stock market improve while the euro uh remains stuck around the 115 to 117 level. That's notable, I think.

SPEAKER_00 3:50

Yeah, so now I think there's an element of investors have certainly been burnt in the past, haven't they, in the last couple of months or so with these headlines, and we've seen sort of being bombastic statements from President Trump that have not really uh stacked up with the reality of the situation. We're seeing headlines out of Iran reportedly this week that they'd um temporarily suspended talks with the US, but the source there was a little bit dubious, and and and actually President Trump has has quickly stamped that speculation out. Um so I think certainly there's an element that seems as Zomark's uh are waiting for more concrete news at least. Um, and that the headlines in the interim, speculation in the interim is is not really being treated um uh as significantly as maybe it was at the start of the war. I think that's that's certainly something that we're that we're seeing, and investors coming more accustomed to these headlines rather than necessarily jumping on the back of jumping off the back of them.

Why EUR/USD Volatility Vanished

SPEAKER_00 4:56

Um the second piece is uh is the European Central Bank. I mean the the ECB is is widely expected to deliver what we expect to be an insurance hike at the June meeting later this month. Uh a move framed not as a start of a new tightening cycle but as a precautionary step to guard against future inflationary spikes. Um and this characterization matters enormously for the euro. Um if the ECB were to signal this is a one and done, the initial reaction could actually weigh on euro dollar as traders price out expectations for subsequent tightening. Um but the guidance that accompanies that decision certainly will be very important, perhaps even more so than the hike itself. Um so, Enrique, what do you what do you expect from this month's ECB meeting? Do you think it'll be an important one? Uh how do you think it'll impact the euro?

SPEAKER_01 5:47

Yeah, no, I agree completely with you. I mean, I think that there's there's little doubt that they're going to hike. And they have tele most of uh ECB officials who have spoken on the subject have telegraphed that they intend to hike. Now the question is right now we have another uh hike and 50% chance of a third hike in the year 2026 pressing to markets, right? Uh so markets are saying we're gonna get another hike in September and maybe 50% chance of a hike by December. So the question is the the the big question that we define at this meeting is whether the ECB validates these projections. Um we have, I mean, inflation has clearly uh spiked on the back of the energy price rises. Um core inflation is seems to be also headed up. There seems to be a lot of uh uh measures on the part of the different governments to um to stop prices, energy prices from going further, which is, I think, um means that the actual inflation data is underestimating the level of inflationary pressures out there, but there's this um there's massive uncertainty, mostly whether uh the extent of the second-round effects. And the problem with the uh European the Eurozone is that the data is comes out very late. So we won't see the impact of energy prices on, say, wage demands and and wage increases until probably later in the summer. So my guess is that we will not resolve these issues at the next ECB meeting in June, that the ECB will continue to give itself flexibility and we'll adopt for any further hikes, we'll adopt a wait and see attitude where they say, well, we're going to be looking at wages, we're going to be looking at core inflation, and we're going to see whether this uh inflationary pressures spill over from the energy sector to the to the other sectors.

SPEAKER_00 7:47

I think that's a fair assessment. It's a difficult balancing act, isn't it, this month's meeting? Because on the one hand, uh energy prices still remain very high, inflation is climbing and surprise to the upside. But then you look at the state of the area economy, activity data's been very weak, the PMIs um uh sub-50, there's a possibility um that we could even see a contraction in the blocks economy in the second quarter of the year, at the very best, another period of stagnation. And then there's an argument, of course, that we've been saying since the beginning of the conflict, actually, there's very little that monetary policy can do against uh supply issues, um, and the ECB really doesn't know the extent to which this energy spike will filter through to second order effects, and they'll have to wait some time before they will find out. Um, so so I agree. Well, I think we will definitely get a hike in June. I think the ECB has essentially boxed its boxed itself in and is now more or less guaranteed to hike, but but the guidance beyond then I don't think they'll they'll give any sort of firm guidance for markets. I think they'll very much keep their options open uh and say they'll await await data, particularly on these second round effects before they commit to more hikes beyond them. But certainly I think I think there's gonna be it's gonna be difficult to justify um aggressive hikes, not just the ECB, but I think across the board this year, given, as I said, it's a temporary supply issue that monetary policy can do little about. Growth is set to be hit hard by the energy spike, particularly in Europe, and labour markets remain pretty weak. There's pretty there's plenty of slack, which would suggest that um that actually those second-order effects might not be quite as severe as maybe initially feared.

ECB Hike And The Guidance Trap

SPEAKER_00 9:42

Um third question on this point. Um, as I said, Eurodollar's been trading in a very tight range. What actually breaks it out of that range? Um, do you think we'll likely need to see uh a significant catalyst or a handful of catalysts? Would it be the ECB, would it be the Fed or or or the Iran war? What do you think breaks us out of this range, Enrique?

SPEAKER_01 10:04

Uh I've been a little bit surprised by the absence of a rebound in the Euro, given how relaxed the rest of financial markets seem to be about the war, right? You would expect Euro if if we're seeing record heights in in uh US stock markets and and basically a fairly placé view of the risks uh among investors, you would expect the euro to be closer to 120 or to 115, what it was before the war started. Um I think that uh the euro is pricing in right now a significant differential in the impact of the war uh in the European economy versus the US economy. The US economy seems to be almost completely unscathed by by the higher oil prices, perhaps not wholly surprising given that the US has become a net energy export exporter. Uh so I still think that a permanent resolution of the war would would bring the euro higher towards 120, but uh we to be honest, we have seen it react less and less uh to what should be positive news about uh the possibility of a ceasefire and uh resumption of of the strait of Ormuz oil flows. So I I think that in order to get back to the levels it was before the war, we need to see it's not enough to see um uh permanent ceasefire, we need to also see better news flow regarding to the European economy, which like you said, seems to be again uh sliding towards not quite recession, but definitely stagnation.

SPEAKER_00 11:51

Yeah, very very very much seems to be holding the euro back. Um let's see what the ECB says on the economy in a couple of weeks' time, I think it's gonna be um obviously very closely watched.

Fed Outlook And Dollar Support

SPEAKER_00 12:04

Um you mentioned the US as well, though, and across the Atlantic, the picture, again, as you said, uh has been been much rosier. Um the US economy appears to be largely shrugging off the energy spike, almost immune to the uncertainty created by the Iran war. If we look at the latest US data, um the job station has been good, job creation clocked in at 7.6 million in April. That was well above forecasts and the highest reading since May 2024. Um PMIs are holding up well, durable goods orders have been solid, growth is is proving resilient in a way that I think very few people expected given where all prices are. Um so the dollar remains pretty well supported despite uh optimism surrounding the war and and safe haven demand theoretically unwinding. Um so I mean I guess that raises a bit of a question about are we maybe now less dovish on the dollar uh than we were even uh a few weeks ago? And I think that argument is becoming increasingly compelling if you look at the resilience of the US economy, maybe suggests that the Fed has every reason now to stay on hold, maybe even hike rates towards the end of the year. The US labor market isn't showing any signs of cracking. So potentially could could these strong fundamentals absorb any selling pressure from an from an end to the war? Uh what do you think, Enrique? Do you think that the dollar is is maybe in a stronger position?

SPEAKER_01 13:38

I think that the news for the last few weeks is supportive of the dollar at the margin. There's still uh a number of reasons uh where the dollar might be under pressure. Uh but one issue that I think has become less worrisome for investors is the the deterioration of institutional quality in the US under Trump. Uh we've seen like the worst measures of the Trump administration, like this slush fund that he had agreed with himself uh recently, uh be turned on by a combination of the courts and the other institutions. I think that part of the reason why the dollar is is outperforming most people's expectations over the last few weeks is that uh the worst case scenarios about institutional degradation in the US Um are not coming to pass. And a clear example is the the Federal Reserve, right? Uh uh not only it looks like uh Trump has given up on rate cuts, but uh markets are selling to pricing that the next move from the Fed will be a hike. Now, obviously there's good reasons for this. There's been um the energy price spike makes it almost inevitable. But um the fact that uh that the Fed seems to have so far successfully resisted uh administration pressure, uh political pressure, it's it's perhaps one of the reasons why the dollar is outperforming most people's expectations.

SPEAKER_00 15:05

Yeah, I think I think if you looked, I mean, even a month or so ago, I think the general expectation we would see a fairly significant winding in rate differentials between say the US um and the rest of the world, or should I say a narrowing, whereby the ECB, for instance, maybe hikes rates two or three times this year. The Fed potentially even cuts rates towards the end of 2026. But we've certainly seen a shift in that regard in the last few weeks, whereby it's now very difficult to see how the Fed doesn't at the very least hold rates throughout the rest of the year, maybe even hikes given the strength of the US economy, uh bubbling US inflationary pressures. But then the ECB, on the other hand, will they hike the the U area economy into a into a recession or or or prolong stagnation? I don't think that they will. Um so certainly that argument from a rate differentials point of view in favour of a of a of a weaker dollar is is not quite as strong as it was even a few weeks ago. Um let's see what happens if we do get news of uh uh of a framework deal this month uh or later or in the next few weeks. That'll be interesting to see how the dollar reacts to that. I think we'll see a bit of an unwinding in in safe haven flows, and then our what our call has been for a few weeks now. It's been that actually once the war is over, markets will will place this added risk premium on the dollar, this Trump risk premium given his erratic decision making, just like we saw post-Liberation Day. I I still think that that will be the case. I still think we'll see that that risk premium being added into the greenback. It's just how much of that downside will be offset by by this strong performance of the US economy and and maybe a more hawkish Fed than we'd perhaps anticipated.

Sterling Faces UK Political Shock

SPEAKER_00 17:02

Brilliant. Finally, I want to talk about sterling because if there's one currency uh where the domestic political backdrop is about uh to get very interesting, then it is the pound. Um June is a genuinely very significant month uh for the UK. We've got the Bank of England decision on the 18th of June, the day after the Fed, and then we've got the the Makerfield by-election on the same day, which is shaping up to be a very significant political test for Prime Minister Keir Starmer, who's been under intense pressure since the local election bloodbath uh for the Labour Party. Um, if Greater Manchester Mayor Andy Burnham wins that seat in the by-election, which looks likely, um markets expect uh that it'll put him in a very strong position for the Labour leadership challenge, not just to trigger a leadership contest, but to win it. He seems to have enough support among both Labour MPs uh and Labor members. Um the question now is though, are markets fully pricing that risk into sterling? Because the pound uh has been largely resilient in the last few weeks. Uh it may have may be underperforming some of its major peers, but actually against the dollar it's holding up quite well. We've not necessarily seen this big blow up in the guilt market. Um, actually, guilt yields have have uh retreated quite a bit in the last uh two or three weeks or so. Do you think, Enrique, this this risk is maybe underpriced? Because if we look at Andy Burnham's rhetoric in the past, his his his track record as mayor, he seems to favor heavy government spending, maybe greater tax hikes, greater guilt issuance. What do you think?

SPEAKER_01 18:50

Yeah, I mean Sterling has been, like you said, outperforming most expectations. It's been on an upward trend since November of last year, uh, only briefly interrupted by by uh the the war. I'm measuring it against uh the euro because uh I think it's the purest measure of idiosyncratic in uh British risk. And against the Euro is is um somewhere near the highest of the last 10 months. Um the perhaps the British economy has been outperforming somewhat the very dismal readings that we see from the Eurozone. That's part of the reason. But yeah, I think that perhaps uh markets are a little too placé about the possibility of uh yet another round of uh spending, yet another round of tax increases in the in the UK. Uh I think that markets are pricing in about a 60% chance of Vernon uh becoming the prime minister at some point this year, which I mean I have no reason to disagree with that. And if that's where you're pricing in, then then perhaps you need to be a little tougher on the pound. Uh because uh any increase in spending and it remains to be seen how how meaningful that pledge to respect UK fiscal rules by Burnham really is, given that he canceled a meeting with investors uh a couple days ago. Uh given that I think that uh Eurosterling near 116 maybe uh maybe uh a little bit high.

SPEAKER_00 20:25

I agree. Yeah, I mean I think uh his recent comments have certainly been slightly more reassuring. Um and uh perhaps are calming investors' nerves with regards to what they can expect under under his premiership. But I I do think this this by-election does worry me a little bit. I think I think markets are going into it maybe a little bit too optimistic, but maybe they're not uh assigning as much of a of a risk premium on the pound and guilt going into it, because I think if if Burnham were to win, which is not a foregone conclusion, like that there's only been one poll released uh on the maker field by-election, and it was very close, it was only actually three percentage points in it. Um but it does look as though he we he's got enough support there in order to win, and then if he does, if he does uh pass that hurdle, then I think it's a pretty clear path into Downing Street. Um what that means is it it means a a shift to the left, most likely, um, in the Labour government, i.e., we're likely to see greater spending pleasures, we're probably likely to see further tax hikes, and for guilt markets, uh the worrying thing is maybe more bond issuance as well, um at a at a pretty dangerous time because this is a time when UK inflation uh sorry, UK growth is is very weak, inflation is is is climbing, um we have an aging population, um, i.e. more dependence uh uh in order for for for tax um to to in order to cover. Um it's a it's a it's a challenging challenging period, and I think if you add into the mix greater tax hikes, greater guilt guilt issuance, I think that's uh gonna be a worry for markets, and I think um I think uh investors will place I think uh a greater premium on on the pound, certainly, um should should Burnham win because I think that that risks um uh an extra fiscal strain on an already already sort of strained fixed fiscal backdrop.

Bank Of England Wait And See

SPEAKER_00 22:34

Um as far as the Bank of England's concerned, as I said, meet the latest MPC meeting will be on the same day, the 18th of June. Um we don't expect a hike. Um it looks as though the Bank of England will sit on its hands for a little bit. Inflation is still rising, growth in the UK is pretty weak. The labour market in particular has deteriorated pretty significantly. We saw another 100,000 net jobs lost from the payroll uh in in April, so it it looks as though there's very limited room for the NPC to hike aggressively, which potentially again it could be another negative factor for the pound and maybe cap some upside. Um what are your last final thoughts on the Bank of England meeting this this month, Enrique? Do you see any uh any sort of significant announcement here? It looks as though they're not likely to hike, but any sort of significant forward guidance?

SPEAKER_01 23:28

No, I think that that they will do the same thing as the ECB. They just will have to wait and see uh to what extent the energy prices start spreading to other sectors. Um it is true that the rates are almost twice as high as the Eurozone. So let's let's not forget that absolute levels also matter. Um the Eurozone is at 2%. Uh the UK is near 4%. That gives it a little bit of uh cushion. They don't they're not under the same pressure to to hike immediately. But yeah, that they're just they're going to try to give themselves as much flexibility as possible. And clearly they they're also a lot more reluctant to hike than the European Central Bank. Because the concerns of overgrowth probably weight heavier in the institution.

SPEAKER_00 24:20

Um no hike expected, maybe sit on their hands for it for a little while, try and offer as little forward guidance uh as possible, I would suspect, and um and wait and see what the data says in um in a couple of months' time. Okay, fantastic. Um that's it from us. Thank you all very much for for watching, for listening. I appreciate your time. Hope you enjoyed it, and we will catch you on the next episode.