Morgan Stanley: Oil power poses a key danger to USD weaknesss

Morgan Stanley reiterates its USD bearish base case, but highlights that a supply-driven surge in oil prices is an important upside risk to the Dollar, potentially triggering a short squeeze in what remains a consensus short USD market.

Key Points:

• Supply-Side Oil Shock = Short Squeeze Risk:
  • A geopolitical supply shock that pushes oil prices sharply higher could lift the USD by ~2% or more, given crowded USD short positioning.
  • Near-term, this could limit investors’ appetite to add USD shorts or increase exposure to oil-sensitive FX pairs.

• Parallels with March 2022:
  • The market is increasingly trading FX based on terms-of-trade dynamics, similar to the reaction after the Russia-Ukraine war began in March 2022.
  • Historically, the DXY peaks and then weakens quickly after geopolitical escalations, implying that any USD rally driven by oil could be short-lived.

• Positive USD-Equity Correlation:
  • The strong correlation between USD and US equities may also cap any significant, sustained USD strength.

• Medium-Term Bearish USD Fundamentals Remain:
  • US rate convergence, hedging flows, and weaker relative growth still point to a weaker USD in the medium term.
  • MS sees a geopolitical-driven USD squeeze as an opportunity for USD bears to re-enter at better levels.

Conclusion:

Morgan Stanley argues that while higher oil prices are a real short-term risk to the bearish USD view, any USD strength on the back of an oil-driven short squeeze should be seen as an opportunity to fade and re-establish short positions, as fundamentals continue to favour a weaker dollar into 2025.

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