While the middle east conflict continues for it's 36th day, financial markets are currently focused on the near term inflation impact of higher crude prices. But medium term growth might suffer more than inflation. Stagflation risks continue to rise sharply, presenting a dilemma for the world’s central banks. USD continues to recover, but the gains have been muted, and FX volatility has been relatively contained compared to commodities and rates. We expect the USD to be supported on risk aversion and higher energy prices, but we also see considerable performance dispersion under the surface. The Asia FX outlook remains broadly bearish given the region’s vulnerability to the oil shock. Headwinds include a sustained rise in energy costs, elevated short-term US interest rates, the compression of growth differentials versus the US, and an unfavourable capital flows picture. Even if the US leaves the war without any further escalation in the coming weeks, a sustained positive reaction in risk markets (and a softening of the USD) is questionable, barring a further decline in oil prices (e.g., the Strait of Hormuz begins to re-open). Without this, the elevated oil price backdrop would continue to adversely affect global growth, drive inflation higher and likely pressure BoP dynamics (i.e., trade account deterioration; portfolio outflows on the negative growth outlook) across most of the world. On a de-escalation narrative, there will initially be risk premium repricing followed by more fundamental considerations such as lost growth, lost trade & lost capital flows. But will de-escalation lead to the resuming of pre war dedollarisation theme. It might but for different reasons. Central bank divergence risks in H2CY26 might halt the current DXY bull run. If this divergence is meaningful which we believe might be a strong possibility, (our view: ECB & BOE hiking by 50 bps total in H2CY26 while Fed cuts by 25 bps) then DXY might see another meaningful correction in H2CY26. Hence our short-term view target for DXY is 102 with stop around 98 (CMP 100). But we don’t expect DXY to sustain above 102 for long in medium term.
