Having spent a career in treasury markets assessing the outlook for the dollar, the latest crisis in the Middle East has shown currency markets following familiar lines.
As tensions between the US and Iran flared, the well-established pattern of dollar strength during periods of geopolitical stress materialised, with dollar assets such as Treasury bonds unmatched in terms of depth, liquidity and perceived safety. This pattern only showed signs of moderation as markets occasionally reassessed the length and trajectory of the conflict.
Indeed, more recent market behaviour suggests that this support might now be waning. Periods of consolidation have reflected uncertainty about whether the conflict will escalate further, or move towards containment, or whether safe-haven flows were ever really justified given the level and nature of the crisis, which could persist.
Oil markets remain central to the overall dynamic that has played out. Prices surged on fears of supply disruption, particularly through critical shipping routes, but they have since shown increased volatility as traders weigh these immediate geopolitical risks against likely demand conditions. This volatility continues to feed into inflation expectations, complicating the outlook for US monetary policy.
Expectations for the US Federal Reserve have therefore become more conditional. While higher energy prices initially strengthened the case for keeping interest rates elevated, any sustained drag on global growth from the crisis could offset this by weakening demand. As a result, the dollar’s support from interest rate differentials is now less clear-cut than it appeared at the onset of the crisis.
Further to these near-term fluctuations, the broader structural concerns surrounding the dollar remain intact, and may, in fact, be intensifying in part because of this crisis.
Fiscal pressures continue to build. The United States is already running large budget deficits of around 6 per cent to 7 per cent of GDP, and even a limited increase in defence spending or other external commitments risks adding further strain. At the same time, elevated interest rates are increasing the cost of servicing this debt. The combination raises questions about the sustainability of US fiscal dynamics over the medium term and the potential implications for investor confidence.
At the geopolitical level, recent developments have reinforced a trend towards fragmentation rather than integration.
US President Donald Trump’s continued use of tariffs, sanctions and financial restrictions as tools of policy is encouraging a gradual shift among some countries to reduce reliance on the dollar-based financial system. While this process remains slow and uneven, it is becoming more embedded in policy thinking across parts of the global economy, with central banks already having reduced holdings of dollar reserves over recent decades.
The Iran crisis has, if anything, sharpened this trend. Countries exposed to geopolitical risk are continuing to explore alternative settlement mechanisms, diversify reserve holdings and strengthen regional financial arrangements. These shifts are unlikely to displace the dollar completely, but they do point towards a steady erosion of its relative dominance over time.
Policy signalling remains another source of uncertainty. Markets have responded not only to concrete developments during this crisis but also to shifts in rhetoric.
At times, messaging has appeared inconsistent, contributing to volatility in currency and equity markets. This reinforces a broader perception that US policy is becoming more erratic and reactive, sometimes aimed merely at calming markets rather than addressing the actual crisis itself. This may have the reverse impact and gradually weigh on confidence rather than boosting it.
Inflation dynamics also remain a key concern. The combination of trade frictions, supply-side disruptions and energy price volatility risks keeping inflation elevated. While this may support nominal yields, it also raises questions about real returns. If inflation proves persistent, it could erode the attractiveness of dollar assets even in an environment of relatively high interest rates.
Taken together, these dynamics highlight a striking paradox. In the short term, geopolitical crises continue to support the dollar through safe-haven demand.
Yet at the same time, this effect is becoming diluted with the recent erratic nature of US policy serving to undercut confidence in the dollar’s safe-haven qualities. They also amplify the longer-term forces that could undermine it, namely rising fiscal pressures, geopolitical fragmentation, policy uncertainty and gradual diversification away from dollar dependence.
The key issue is not whether the dollar will lose its dominant role all of a sudden, but whether the pace of its relative erosion is accelerating. Recent market behaviour suggests that while the dollar remains the default refuge for investors in times of stress, its strength is becoming more episodic and less absolute.
For now, the latest phase of the crisis has extended the dollar’s resilience a little. But it has also provided a further reminder that the very forces that sustain the currency in the short term may actually contribute to weaken its foundations further out.
Tim Fox is a partner at Capital Gate Advisors and is the former chief economist of Emirates NBD
