Israel-Iran conflict highlights dollar's tarnished safe-haven appeal

A dramatic spike in the potential for all-out war between Israel and Iran would typically be expected to spark an immediate and strong rally in the US dollar, with investors seeking the safety and liquidity of the world's reserve currency.

That didn't happen on Friday.

The dollar's response to Israel's strikes on Iranian nuclear facilities and military commanders, followed by Tehran's initial threats and retaliation, was pretty feeble. The dollar index, a measure of the currency's value against a basket of major peers, ended the day up only around 0.25 percent.

To be sure, the dollar fared better than US stocks or Treasuries, which both fell sharply on Friday. But with oil surging over 7 percent and gold up a solid 1.5 percent, a strong 'flight to quality' flow would have lifted the dollar more than a quarter of one percent.

The US currency's move was particularly weak given the dollar's starting point on Friday. It was at a three-and-a-half year low, having depreciated 10 percent year to date, with sentiment and positioning heavily bearish. Yet a significant geopolitical shock generated barely a knee-jerk bounce.

For comparison, the dollar rose more than 2 percent in both the first week of the 2006 Israel-Lebanon War and in the week following Israel's invasion of Southern Lebanon last year.

The dollar's weak response to this latest Middle East conflict supports the narrative that investors are now reassessing their high exposure to dollars, in light of some of the unorthodox policies put forward by US President Donald Trump in recent months.

The dollar was down slightly early on Monday, and gold and oil were giving back some of Friday's gains too, as markets regained a foothold at the start of a busy week packed with key central bank meetings.

That latter part of that argument hasn't changed.

The dollar accounts for almost 60 percent of the world's $12 trillion FX reserves, with its nearest rival, the euro, accounting for around 20 percent. Almost two-thirds of global debt is denominated in dollars, and nearly 90 percent of all FX transactions around the world has the greenback on one side of the trade.

That means traders, financial institutions, businesses, consumers and governments still need to be more exposed to dollars than any other currency, even if they question the direction of current US policy.

However, the dollar's downside 'structural' risks are growing, analysts at Westpac noted on Sunday, as concern over Washington's fiscal health and policy uncertainty erode the dollar's 'safe-haven identity'. Investors are now looking to hedge their large dollar exposure more than ever.

If this dampens their instinctive demand for dollars in periods of sudden geopolitical tension, uncertainty and volatility, then the so-called 'dollar smile' theory could be challenged.

This 'smile' is the idea that the dollar appreciates in periods of financial market stress as well as in 'risk on' periods of strong global growth and investor optimism, but sags in between. This idea was first outlined over 20 years ago by then currency analyst and now hedge fund manager Stephen Jen.

If the Israel-Iran conflict continues to escalate, that dollar smile could get rather lopsided.

[Jamie McGeever has been a financial journalist since 1998, reporting from Brazil, Spain, New York, London, and now back in the US again. Focus on economics, central banks, policymakers, and global markets - especially FX and fixed income.]