Sterling's Opening: Why the ECB May Be About to Make a Mistake

Markets spent this week pricing two outcomes. The first was an extension of the US-Iran ceasefire, which arrived late Wednesday. The second was a reopening of the Strait of Hormuz that would allow oil exports to resume in meaningful volume. That has not arrived, and is unlikely to arrive on any near-term horizon.

Brent closed Wednesday at $101.91, up more than 3 percent on the day. By Friday morning it was trading around $105, with WTI in the $93 to $96 range. The ceasefire was extended but the Islamabad talks never took place. Iran refused to attend, Vice President JD Vance cancelled his trip, and the Iranian Revolutionary Guard seized two more container vessels attempting to transit the Strait. The United States has maintained its naval blockade of Iranian ports. Tehran has stated that the Strait will not reopen while that blockade remains.

The short version is that the ceasefire now stabilises the military situation without resolving the economic one. Oil is above $105 with no clear path lower. Physical supply remains constrained. The conflict has entered a holding pattern that resembles a slow-burning stalemate more than a path to resolution.

That matters for currency markets, but not in the way the obvious interpretation suggests. The dollar should, in theory, catch a stronger bid in this environment than it has. The week's more interesting developments are not about oil at all. They are about the structural credibility of the dollar, a strategic call from the European Central Bank that we disagree with, and a setup for sterling that is not being priced.

This piece is about those three things.

On Wednesday, Treasury Secretary Scott Bessent told the Senate Appropriations Committee that "many" US allies in the Persian Gulf, along with a number of Asian nations, have requested currency swap lines. The statement moved the story from Tuesday's White House framing of "preliminary discussions" to an acknowledgement that there is active demand from dollar-dependent Gulf states for US dollar liquidity backstops.

This is worth pausing on.

A currency swap line is a facility through which a foreign central bank can borrow dollars from the Federal Reserve or the US Treasury against its own currency, to maintain dollar liquidity in its domestic financial system. The UAE central bank governor, Khaled Mohamed Balama, raised the idea with Bessent and Fed officials in Washington last week. The Wall Street Journal reported that the UAE privately warned it may have to use the Chinese yuan for oil sales if dollar liquidity tightens further. The UAE embassy has since denied it requires external financial backing, but Bessent's Senate testimony confirms the substance of what is happening.

For most of the past fifty years, Gulf states have been the largest single source of structural demand for the dollar. The 1974 Saudi-US agreement to price oil in dollars created the petrodollar system, and with it a self-reinforcing cycle in which Gulf oil revenues were recycled into dollar-denominated assets, primarily US Treasuries. The cycle works because Gulf states need dollars, global importers need dollars to buy oil, and the United States benefits from a permanent bid for its currency and its debt.

What happened this week is a signal that the cycle is under stress. When the largest recipients of dollar revenue in the world are asking Washington for dollar liquidity support, and privately floating yuan-denominated oil settlement as leverage, the implication is clear. The dollar is not being questioned as a medium of exchange in Gulf commerce. But its credibility as an unquestioned source of liquidity, something that simply is abundant in the system, is being tested for the first time in a generation.

Deutsche Bank flagged last month that the conflict could be remembered as a key catalyst for erosion in petrodollar dominance. The Asia Society's 2025 report on the petroyuan described the decline of the petrodollar in the Gulf as a matter of when rather than if. The events of this week do not collapse the petrodollar system, but they do chip away at a component of it that many participants assumed was stable. For currency markets, that cumulative chipping away is the story.

The dollar is now under pressure from three directions at once, and each reinforces the others.

The first is the Gulf situation just described. The second is the Federal Reserve. Kevin Warsh's Senate Banking Committee confirmation hearing on Tuesday was, in procedural terms, a standstill. Senator Thom Tillis confirmed publicly during the hearing that he would continue to block the nomination until the Department of Justice drops its criminal investigation into Jerome Powell. Without Tillis, the nomination cannot leave committee. Powell's term expires on 15 May. Powell has stated he will remain as chair pro tempore if no successor is confirmed. President Trump has threatened to fire him if he does.

The substance of Warsh's testimony was, as we wrote on Tuesday, a careful rhetorical balancing act on Fed independence. He stated that monetary policy independence is essential while also stating that the operational independence of monetary policy is not particularly threatened when elected officials publicly express views on interest rates. That second position creates rhetorical space for the kind of White House pressure on rates that has been a consistent feature of the current administration.

The third front is broader still. The changes to norms of global economic governance over the past year, from tariff policy to trade threats to the use of Treasury instruments as leverage over foreign policy questions, have created a backdrop in which the dollar's position as the neutral reserve asset of the global financial system is being questioned in ways it was not eighteen months ago. None of these changes alone are decisive. But the cumulative effect on institutional credibility is real, and it is visible in how the dollar has traded over the past several months.

The Dollar Index is near 98.5, having recovered modestly this week on safe-haven demand from the continued Iran standoff but still well below the levels it would normally trade at given its safe-haven status during a geopolitical crisis of this severity. The DXY has not rallied meaningfully despite oil returning above $100, despite a visible deterioration in European growth data, and despite a genuinely uncertain outcome for the Fed Chair transition. A healthy dollar in this environment would be well into the low hundreds on DXY. Its inability to respond to what should be supportive inputs is the market's verdict on these accumulating credibility questions.

Our view is that the dollar is overvalued against this backdrop. Not dramatically. But enough that the path of least resistance over the coming months is lower.

Against this picture, one might expect the euro to be the obvious beneficiary. It is not, and the reasons matter.

On Wednesday, Germany's Economic Affairs Minister Katherina Reiche confirmed that the government is halving its 2026 GDP growth forecast from 1 percent to 0.5 percent. The 2027 forecast was cut from 1.3 percent to 0.9 percent. Italy simultaneously revised its 2026 GDP forecast down to 0.6 percent from 0.7 percent, with Finance Minister Giancarlo Giorgetti warning that the numbers may need to be reviewed, adjusted and updated in light of the continued conflict. The German ZEW Survey of Economic Sentiment collapsed to minus 17.2 in April from minus 0.5 in March, a swing of more than sixteen points in a single release.

The asymmetry between the United States and Europe on the oil shock is structural. The US is a net energy exporter and has been since late 2019. When oil prices rise, American energy producers generate more revenue, which partially offsets the inflationary and consumer-demand impact of higher petrol prices. Europe is a net importer and, crucially, imports the vast majority of its natural gas. When oil and gas prices rise, European industrial activity contracts in real time, because energy-intensive manufacturing becomes uneconomic at the new prices.

The difference shows up in the political conversation. American politicians are discussing how to adjust to higher energy prices. European politicians, increasingly, are discussing shutting production down because the energy is not available at any price. A chemicals plant in North Rhine-Westphalia cannot simply pay more for gas that is not flowing. Qatari LNG transiting the Strait of Hormuz remains disrupted. The longer the conflict persists in its current holding-pattern form, the more real industrial damage is locked in to the European economy.

That is the story that has not yet been fully absorbed by the euro's exchange rate.

What makes the European picture complicated is the central bank's reaction function.

The ECB held its deposit rate at 2.0 percent at the 19 March meeting. Since then, President Christine Lagarde has signalled publicly that the Governing Council is prepared to raise interest rates in response to the inflationary pressure from the oil shock, even if that pressure proves temporary. Market pricing now has the ECB's key rate reaching at least 2.5 percent by year-end. The 29 to 30 April meeting is the next decision point.

The consensus among major banks is genuinely split on what happens from here. Barclays and JPMorgan now expect three ECB hikes this year. Morgan Stanley expects two. UBS expects a hold. Deutsche Bank's base case is rates steady through 2026 with the next move a hike in mid-2027. A recent Reuters poll of sixty economists found twenty-one expecting at least one hike, compared with three of seventy-two two weeks earlier. This is not a market that is confident the ECB will hike. It is a market that is pricing a wide range of outcomes.

Our view, for what it is worth, sits on the dovish end of that consensus. We do not think the economic backdrop supports meaningful hikes from here.

The ECB has a single-mandate constitution focused on price stability, and its governing council is scarred by the 2021 to 2022 episode in which it was slow to respond to inflation. That experience is clearly informing current policy. Under its own adverse scenario, headline inflation could peak at 4 percent this year. Under its severe scenario, it could reach above 6 percent in early 2027. A central bank with those projections and a single mandate has a genuine institutional case for hiking, and we take that case seriously.

But the economic backdrop today is fundamentally different from 2021 in ways the hawkish case may be underweighting. In 2021, the inflationary shock landed in a post-pandemic economy with strong underlying demand, supply chain bottlenecks, and acute labour shortages. The pass-through into broader prices was rapid because the conditions for pass-through were present.

In 2026, the backdrop is different on every dimension. Underlying demand is weak. Germany is stagnating. Italy is downgrading its fiscal projections. The labour market has loosened, with European unemployment rising rather than tightening. And the current inflationary impulse is a pure supply shock driven by the Strait of Hormuz, not a demand-led inflation.

Hiking into this picture is unlikely to reduce inflation meaningfully because monetary policy cannot make oil cheaper. But it will actively damage growth, which is already fragile. The parallel to draw, in our view, is not 2022 but 2011, when Jean-Claude Trichet raised rates into a weakening economy and had to reverse course within months. That is not a consensus view. It is ours.

If the growth data continues to deteriorate, and we think it will, the ECB may be forced into cuts rather than hikes in the second half of the year. That would be a sharp reversal from current market pricing. The euro's strength, to the extent it depends on the ECB continuing to signal hikes, looks more fragile than consensus framing suggests.

There is a reasonable counter-argument to the bullish EUR/USD view. If Europe is in genuine trouble, why should the euro be anything other than weak?

The answer is that EUR/USD does not need euro strength to move higher. It can move higher on dollar weakness alone.

European weakness is increasingly being priced in. Positioning data from the CFTC shows speculative shorts on the euro building over the past several weeks. German bond yields have moved to reflect a growth slowdown. European equity indices have underperformed their US peers through April. The Germany 0.5 percent GDP downgrade and Italy's revision land in a market that already knew Europe was weakening, and are visible in how European assets have traded.

What is less fully priced is the combination of three things: a US economy that is showing softer growth signals beneath the safe-haven dollar bid, a dollar that is under structural credibility pressure for reasons that have nothing to do with the euro, and ECB hawkish signalling that may not sustain if growth continues to deteriorate.

In that setup, EUR/USD can grind higher from 1.17 toward the 1.18 to 1.20 range even if the European growth outlook continues to weaken. The move would be a mechanical consequence of dollar weakness, not a bullish statement on Europe.

The more interesting relative call within this backdrop is not the euro. It is sterling.

Sterling sits in an unusual position this week. GBP/USD is close to 1.35, having climbed roughly 2.5 percent through April but softening modestly into Friday as safe-haven dollar demand returned. The UK unemployment rate fell to 4.9 percent in the three months to February, down from 5.2 percent. But the fall was driven largely by people leaving the workforce altogether rather than by new jobs being created, which is a weaker signal than the headline number suggests. Wage growth has slowed to 3.6 percent, the lowest since November 2020. UK CPI for March came in at 3.3 percent, up from 3.0 percent in February and in line with consensus, keeping a 30 April BoE hike live without decisively raising its probability.

It would be a mistake to mistake sterling's position for unambiguous strength. The UK has real downside risks that are not in the current exchange rate. Debt-to-GDP now sits around 100 percent, up from 85 percent before the pandemic. The May local elections are a genuine political risk point, with internal Labour pressure on the Prime Minister well reported and a possible leadership challenge over the summer not fully priced. The autumn Budget will be another pressure point as fiscal slippage becomes harder to avoid. The OBR has already revised UK growth down to 1.1 percent for 2026. If any of these risks materialise sharply, sterling is exposed.

But sterling does not need a strong UK story to appreciate modestly from here, because its appreciation is being driven by weakness on both the dollar and euro sides of the equation.

The Bank of England has more room to manoeuvre than either the Fed or the ECB over the coming quarters. Inflation is elevated but the rate is at 3.75 percent, well above its estimated neutral rate. If global energy pressures stabilise and UK wage growth continues to moderate, the BoE can hold rates steady without creating acute market pressure. That relative stability, against a Fed navigating a complex political and inflation backdrop and an ECB that may be forced to reverse hawkish signalling, creates a narrow window in which sterling benefits from yield-differential dynamics without requiring its own story to be the reason.

It does not require a bullish UK view to be constructive on sterling. It requires only the recognition that the other two major central banks are in harder places, and that the UK sits in the middle with fewer acute near-term catalysts than either.

For GBP/USD, our view is that 1.35 is a floor that holds and that the pair has room to move toward 1.37 and potentially higher over the coming weeks if the dollar's structural pressure continues. Major bank consensus runs from 1.35 to 1.47 for year-end, with most clustering at 1.36 to 1.40. Our view sits at the more constructive end of that range.

For GBP/EUR, the picture is more nuanced. If the ECB signals a hike at the 30 April meeting, the euro could see a short-term spike against sterling. But if the ECB holds, or if the growth data continues to erode the case for a hike in the meetings that follow, GBP/EUR has room to recover from its current levels.

The asymmetric positioning is the point. Sterling's absolute story is not bullish. Its relative story, against a dollar under structural pressure and a euro tied to a central bank that may be about to make a policy error, is the better one.

For finance directors managing exposure through the next six weeks, three observations are worth taking seriously.

First, the dollar's structural weakness is unlikely to reverse quickly even if the oil picture improves. The credibility questions around the Fed transition, the Gulf swap line situation, and the broader institutional backdrop will persist beyond any single data release. Dollar purchases for the remainder of Q2 are likely to be executable at meaningfully better levels than current rates imply.

Second, the euro's current strength rests partly on ECB hawkish signalling that we think may not sustain. If you have euro exposure that needs to be covered, the current strength is an opportunity to act on, not a trend to wait on.

Third, sterling is in a better relative position than the domestic story suggests, though the UK's own downside risks should not be ignored. GBP/USD buyers should not assume that 1.35 is a temporary peak. It may prove to be a staging area for further strength rather than a ceiling.

The broader point is that this is no longer a simple risk-on, risk-off market. It is a market being reshaped by three central banks whose outlooks are increasingly divergent, by a dollar whose structural role is being questioned, and by a European economy where the political conversation is about stopping production rather than adjusting to higher prices. In that environment, timing matters more than direction, and understanding the relative positioning of currencies matters more than chasing single data prints.

The ceasefire extension this week did not resolve anything. It simply extended the holding pattern. What happens in currency markets over the coming weeks will depend far more on the Federal Reserve, the European Central Bank, and the Bank of England than on what happens in the Gulf. The Gulf is now, as we argued on Tuesday, a second-order variable. The first-order variables are in Washington, Frankfurt, and London, and they are all moving in ways that support a more considered positioning than the market is currently reflecting.