Financial markets are back in risk-off mode as Middle East peace talks show signs of stalling, with both sides continuing to enforce blockades on shipping through the Strait of Hormuz. Brent crude is holding above $100 once again, equity futures are setting up for a pullback at the open, and the dollar is catching a bid as traders revert to safe-haven and terms-of-trade playbooks, selling the currencies most exposed to an energy price shock.

The euro is trading sharply weaker after economic activity unexpectedly contracted in early April as stagflationary conditions took hold. The eurozone flash composite purchasing manager index dropped to 48.6—its first sub-50 reading in sixteen months and well below the 50.1 consensus—amid what S&P Global called the sharpest surge in cost pressures since 2000 outside the pandemic, with services contracting at a pace not seen since the 2021 lockdowns. The slump follows a tumble in the European Commission’s business and consumer sentiment surveys in March, reinforcing a pattern of deteriorating momentum. Investors are still pricing in two rate hikes from the European Central Bank by year-end, but conviction is ebbing, and rate differentials are turning slightly less supportive.

Across the Channel, the British pound is outperforming its ex-dollar rivals after business activity unexpectedly rose in early April, suggesting that the war is driving companies to front-load purchases ahead of expected price increases. S&P Global’s flash composite PMI climbed to 52 from 50.3—well above the 49.9 consensus—but this came at a cost, with input-price inflation in manufacturing hitting its highest since November 2022, while services-sector cost inflation posted its sharpest monthly rise on record. Traders are pulling forward rate hike expectations, with swap markets now pricing two quarter-point increases by September, up from December previously.

Yields were little moved yesterday after Treasury Secretary Scott Bessent told a Senate committee that several Persian Gulf and Asian countries have requested foreign exchange swap lines with the US—arrangements under which the Treasury or Fed lends dollars against collateral to foreign central banks, which distribute them to domestic institutions before ultimately unwinding the transaction. These lines exist because so much global trade, debt issuance, and financial activity is denominated in dollars that, during periods of stress, foreign banks can face acute funding shortages their own central bank cannot resolve by printing local currency alone. Bessent framed the requests as a tool to “maintain order in the dollar funding markets” and “prevent the sale of US assets in a disorderly way,” but that rationale is hard to square with current conditions: there is little evidence of strain in cross-border dollar funding markets. The Gulf states’ desire for a liquidity backstop is understandable given their exposure to the conflict, but the broader suggestion that “disorderly” dollar selling is a live risk seems driven by political imperatives more than market realities.

Next week brings a raft of important data releases and monetary policy decisions, offering traders a welcome distraction from the conflict—and a reminder that its economic effects are only beginning to bite. Canada will publish somewhat-stale February output numbers and a labour market update, while across the Atlantic, Eurostat will release its first estimate of euro area harmonised inflation, underlining the extent to which price pressures are intensifying. In the US, the Conference Board’s closely watched consumer confidence reading for April will be followed by the Bureau of Economic Analysis’s first-quarter gross domestic product print and March personal income and outlays report, before the Institute for Supply Management’s manufacturing survey rounds out the week, helping clarify whether the economy is buckling under the weight of geopolitical uncertainty or proving more resilient than feared*.

Central bankers across the major economies will almost certainly pivot away from forecast-driven guidance, instead leaning on incoming data and doing what they can to preserve optionality. Early readings point to a transitory price shock that could force policymakers onto the sidelines, but it is not yet clear that this will trigger an unanchoring in inflation expectations or tip advanced economies into recession. Traders expect rates to stay on hold for now, but still see risks tilted toward hikes by year-end in most markets outside the US, with inflation viewed as the greater threat. We expect this balance to shift in the coming months, with downside exposures coming into view more clearly as supply shortages impact growth. Rate differentials are poised for more turbulence, and currency markets will almost certainly find themselves on the front line.

*We would bet on resilience for now. The old saying—that “war is God’s way of teaching Americans geography”—predates modern cable television and social media. There is little evidence that consumers and businesses are changing their behaviour in response to the conflict.