28.05.202612:41 Forex Analysis & Reviews: EUR/USD: lose-lose effect - why market ignores exchange of strikes between United States and Iran?

The euro/dollar pair updated this week's low today in response to the escalation in the Middle East, and despite active discussion of a "memorandum of understanding," the United States and Iran exchanged strikes, casting doubt over the prospects for the diplomatic process.

According to CNN, US forces carried out an airstrike on a military target inside Iran after Tehran launched four attack drones at a merchant vessel flying the US flag. US forces intercepted the unmanned aerial vehicles and then struck a ground launcher used for UAVs in the Bandar Abbas area, preventing a fifth launch.

The Islamic Revolutionary Guard Corps, for its part, said it had retaliated with an attack on a US air base in Kuwait from which the strike on Iran originated.

In response to the incident, traders pushed EUR/USD to a weekly low and tested the 1.15 area, trading as low as 1.1587. At the same time, sellers were unable to hold their positions—already at the start of the European session, the pair returned into the 1.16 area, where it has traded for the fourth consecutive day.

This suggests that selling below the 1.1610–1.1670 range remains risky even as risk aversion rises. Judging by market reaction, investors still price in a scenario of limited escalation and a continuation of the diplomatic track between the United States and Iran. Despite today's exchange of strikes, oil is rising only moderately, and demand for safe-haven assets, including the US dollar, remains relatively subdued. All of this indicates that market participants do not view the incident as the start of a full-scale renewal of conflict.

What explains this market resilience? Largely the muted market response reflects that the negotiation process has not been irreversibly derailed. For both countries, a new phase of full-scale military action would constitute a "lose-lose" scenario in which political and economic costs would far exceed any potential gains.

The United States, for example, risks stagflation amid accelerating CPI and PCE inflation and slowing GDP growth. In the event of renewed hostilities Brent could rise to $110–$120 a barrel, with attendant consequences—higher Federal Reserve policy rates, increased recession risk, and so forth. It should also be remembered that US midterm congressional elections are scheduled in November, and ahead of that, the White House needs to demonstrate foreign policy success rather than be seen to embroil the country in another "forever war" in the Middle East. A prolonged air or, even more so, ground campaign could cost the Trump administration the support of centrist voters, who are sensitive to both pump prices and casualties among US service personnel.

A full-scale war would be disadvantageous for Iran as well, principally because of economic vulnerability. The Islamic Republic depends heavily on oil exports and external trade channels; a blockade of the Strait of Hormuz, which Tehran uses as a lever, hurts Iran itself. Without oil revenues and amid galloping inflation, the rial risks collapse, which would paralyze the domestic market. Moreover, full-scale warfare would raise the risk of destruction to the country's energy infrastructure, assets that took decades to build. Despite Iran's substantial arsenal of ballistic missiles and drones, US military forces are capable of disabling key oil and gas infrastructure.

For these reasons, most market participants are confident that negotiators will eventually find common ground and agree on a mutually costly but stabilizing deal. Moreover, intermediaries in Pakistan and Oman have confirmed preparations for further contacts between Washington and Tehran, and both sides still allow for the possibility of a nuclear-related agreement.

Today's muted market reaction indicates that investors do not expect an immediate "happy ending" in the form of a rapid reopening of the Strait of Hormuz, but they continue to regard de-escalation as the base case.

Market participants have already adapted to episodes of "controlled escalation": exchanges of strikes are seen more as bargaining pressure in talks than as an abandonment of a deal.

For these reasons, traders are reluctant to open large directional positions either in favor of the "safe" dollar or in favor of the "risk" euro. It appears likely that EUR/USD will trade in the 1.1610–1.1670 corridor—the lower and upper Bollinger band lines on the H4 chart—until the Middle East conflict is finally resolved. Under these conditions it is prudent to consider opening long and short positions near the corridor boundaries.