USDJPY Slides 1.15% Leading FX Decline; EUR, GBP Edge Lower

Traders in North America are observing the Labor Day holiday.

Even though US and Canadian stock and bond markets are shut for the holiday, the forex market remains active. The dollar is trending lower, with the biggest drop coming against the yen at -1.15%. Several factors are driving the move:

• Expectations for a Bank of Japan rate hike are growing. Markets now anticipate a 25-basis-point increase next week, and possibly another later this year.
• Yield spreads are narrowing as Japanese bond yields climb relative to US ones. A smaller interest-rate differential between the US and Japan reduces the incentive to hold dollars versus yen.
• Concerns about intervention persist. Japan’s historic yen-buying operation is still on traders’ minds, curbing aggressive dollar-yen buying and possibly prompting short covering in the yen.
• Unwinding of carry trades is underway. Investors who borrowed yen at low rates to fund purchases of higher-yielding assets are now buying yen back as the rate outlook shifts.
• Technical factors are also at play. USDJPY fell through support around 155.15, activating stop-loss orders and speeding the move toward 154.00.
• Holiday-thinned liquidity is amplifying the move. With US markets closed for Labor Day, reduced trading volumes may be exaggerating the price action.

Against the euro and pound, the dollar’s decline is more modest, at -0.10% and -0.12% respectively.

Geopolitical tensions in the Middle East escalated over the weekend.

Heightened tensions in the region contributed to higher oil prices at the start of the trading week.

The most notable event was a direct confrontation between the US and Iran. Iran launched ballistic missiles at two US Navy vessels, but no American service members were harmed.

In response, the US struck three Iranian oil tankers and warned that more could be targeted.

Shipping traffic through the Strait of Hormuz has slowed significantly.

Transit through the strait has dropped sharply. Iran is set to declare a new restricted zone and shipping corridor in the Gulf, raising the risk of more disruptions at this critical energy chokepoint.

Other developments in the region:

• Clashes between Israel and Hezbollah escalated. Hezbollah sent drones toward Israel, and Israel conducted more strikes in southern Lebanon.
• Israel also continued its strikes in Gaza over the weekend.
• Israeli Prime Minister Benjamin Netanyahu reportedly instructed the removal of illegal settler outposts in the West Bank after US pressure regarding rising settler violence.

Oil prices are rising.

The oil market is reacting to the heightened geopolitical risk:

• WTI crude has gained $0.88, or about 1.0%, to $92.36.
• Brent crude has risen $1.21, or 1.25%, to $97.48.

The importance of the Strait of Hormuz:

A large portion of global oil and LNG shipments traverse the Strait of Hormuz. Although actual supply has not yet been substantially reduced, the risk of disruption alone can drive prices up.

Shipping firms could also encounter increased insurance, security, and transport costs, which may eventually be passed on in oil prices.

What is the geopolitical risk premium?

The extra amount that buyers are prepared to pay due to the threat of a future supply interruption is known as a geopolitical risk premium.

Traders should note that oil markets price in expectations, not just present supply. Prices can climb ahead of an actual shortage. On the other hand, if tensions subside and shipping normalizes, oil could rapidly surrender some of its gains.

What to watch for next:

Worries now extend beyond the Strait of Hormuz. The weekend brought direct attacks on US warships and Iranian oil tankers, plus a further sharp drop in commercial shipping through the strait.

So long as shipping is constrained and the threat of retaliation persists, oil prices are expected to carry a geopolitical risk premium. The key question is whether the conflict stays contained or broadens into further attacks on tankers, energy infrastructure, or other shipping routes.