Economic & FX Outlook Q2 2026

US Dollar Outlook: Safe Haven or Last Resort?

Crisis Drives Safe Haven Flows to the Dollar

The US dollar is on course for its strongest monthly gain in almost a year, as investors flock to safe assets amid an escalating US-Iran conflict that is spilling across the region. The resulting disruption to global energy supplies has triggered a sharp repricing across financial markets, with the dollar emerging as a primary beneficiary.

What appears to have caught everyone off guard is the resilience of the Iranian regime, even after the loss of the senior leadership and relentless aerial bombardment of military and government sites. The ability of its fractured remnants to sustain a de facto blockade of the Strait of Hormuz—through which roughly one-fifth of global oil supply flows—has had an outsized impact on both energy markets and investor psychology. Sporadic attacks on US regional allies have further heightened anxieties, reinforcing fears of a prolonged and costly conflict with no resolution in sight.

Higher for Longer—Again

The implications for the global economy are profound. Elevated energy prices are feeding directly into inflation expectations, while also raising the risk of a broader slowdown. In the US, this has forced the Federal Reserve into a more cautious stance. As Fed Chair Jerome Powell noted during the March 18 meeting, the inflationary consequences of the conflict are likely to emerge over the medium term, though the scale and persistence remain uncertain.

Pump Prices Put Inflation Back in Focus

Source: tradingeconomics.com

Markets, however, are increasingly assuming the disruption will endure, and expectations for monetary policy have shifted materially as a result. Rate cuts that were priced in at the start of 2026 have given way to the possibility of further tightening, or at the very least a prolonged period of elevated rates. This “higher for longer” narrative has added further support to the dollar, complementing its safe-haven appeal.

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Yet dollar strength masks underlying fragilities in the US economy. Even prior to the energy shock, growth dynamics were weakening. The latest non-farm payrolls report showed that 92,000 jobs were shed in February, while GDP growth slowed sharply to just 0.7% (annualised, quarter-on-quarter) in Q4 2025. The latter was exacerbated by the longest government shutdown on record, reflecting deep fiscal and political divisions.

Concerns are also mounting that the US is experiencing a K-shaped recovery. While technology investors have benefited from strong equity performance, broader economic momentum is weakening. This divergence raises questions about the sustainability of recent gains, given the increasing concentration in a single sector. At the same time, rising energy and infrastructure costs threaten AI profitability, while its commercialisation remains only gradual, potentially yielding problems ahead.

The Jobs Engine Is Stalling

No Easy Policy Path

For the Fed, the policy dilemma is becoming acute. Inflationary pressures are clearly building, with the Fed’s preferred PCE measure reaching 3.1% in February and forecasts pointing higher still. At the same time, growth indicators are softening. In this environment, prioritising rate cuts to support activity risks entrenching inflation, particularly given the visibility of higher energy prices and pump costs to consumers. As such, the bar for easing policy appears significantly higher than before.

Domestic Politics Clouds the Outlook

Political dynamics add a further layer of complexity. President Trump faces mounting pressure ahead of November’s mid-term elections, particularly as rising fuel costs weigh on household finances. His renewed push for tariffs—despite legal setbacks to earlier measures under the IEEPA—has introduced additional uncertainty into the global trade environment. The shift to alternative mechanisms such as Section 122, while legally viable, is more constrained and dependent on Congressional approval, potentially limiting its effectiveness yet still entrenching uncertainty.

Encouragingly for markets, some recent developments have helped restore perceptions of Federal Reserve independence. The nomination of Kevin Warsh as a successor to Powell, alongside failed attempts to politically pressure the Fed leadership, has helped anchor expectations that monetary policy will remain guided by economic fundamentals rather than political expediency. This institutional credibility remains a cornerstone of the dollar’s global standing.

Bondford’s Outlook

Bloomberg consensus forecasts suggest a weaker US dollar over the coming 12 months, with losses expected against both the euro and the pound—most notably versus the euro. However, this headline view masks a striking divergence in expectations, with forecasts spanning a wide range. This dispersion underscores the unusually high degree of uncertainty facing currency markets, as investors grapple with the evolving trajectory of the US–Iran conflict, its impact on energy prices, and the broader implications for US growth and monetary policy. Given this wide dispersion in expectations, it is helpful to frame the outlook through a set of plausible scenarios:

• Prolonged Conflict
  If the Iran conflict continues to disrupt energy markets into the summer, elevated oil prices are likely to sustain inflationary pressures globally. In this scenario, the Fed remains firmly on hold—or even leans toward tightening—while risk aversion supports continued inflows into dollar assets, bolstering its strength.

• Gradual De-escalation
  A partial easing of tensions, with reduced disruption to oil flows, would alleviate inflation concerns and allow markets to refocus on underlying economic fundamentals. With US growth already softening, expectations for eventual Fed easing could re-emerge, limiting further dollar upside.

• Sharp Resolution
  A swift resolution to the conflict would likely trigger a sharp fall in energy prices and a rebound in global risk appetite. In such a scenario, the Fed could pivot more decisively toward rate cuts to support a weakening domestic economy, leading to a pullback in the dollar from current levels.

Across all scenarios, political developments in the US, particularly trade policy and the mid-term election cycle, will remain a key swing factor for investor sentiment and currency markets.

Summary

The dollar’s near-term strength is built on uncertainty—but its durability will depend on whether inflation or growth ultimately proves the greater risk.

Euro Outlook: Knocked Off Course By The Energy Crisis

From Four Year High to Shock Exposure

In February the euro was riding high, trading at a four-year peak against the dollar. Safe-haven flows had supported the currency amid mounting political uncertainty emanating from the US, including the threats over Greenland, the undermining of Fed independence, and legal challenges to tariff policy. For a time, the euro benefitted from relative stability and a broadly constructive macro backdrop in the Eurozone.

March, however, has told a different story. The eruption of hostilities in the Middle East and the resulting energy price shock have exposed familiar vulnerabilities in the Eurozone economy. The scars of the 2022 energy crisis remain fresh, and the region now finds itself once again at the epicentre of a global supply squeeze.

Several factors amplify this exposure. European gas reserves, depleted after a difficult winter, are at their lowest starting point for the refilling season since Russia’s invasion of Ukraine. At the same time, the continent remains heavily reliant on seaborne LNG imports, placing it in direct competition with Asia for limited global supply. This dynamic is likely to intensify price pressures as countries scramble to rebuild inventories ahead of next winter.

EU Natural Gas Prices Have Spiked, But remain Far Lower than in 2022

Compounding the issue is the fiscal dimension. Governments are under renewed pressure to shield households from another cost-of-living shock, raising the prospect of further expansive—and often poorly targeted—support measures. This comes at a time when public finances are already strained by pandemic-era spending and rising defence commitments, creating an increasingly concerning fiscal backdrop.

Unsurprisingly, investors have responded by repricing European assets, prompting a sharp correction in the euro.

ECB at a Crossroads

Attention has now shifted to the European Central Bank (ECB) and its potential response. Until recently, markets had expected the ECB to remain on hold throughout 2026. Inflation had broadly stabilised near target, and there were tentative signs of improvement in the growth outlook. The prevailing narrative was one of cautious optimism, Europe was in a “good place”, allowing policymakers to adopt a wait-and-see approach.

That narrative is now under strain. At its March meeting, the ECB held rates steady at 2% for the sixth consecutive time, but were keen to stress both upside risks to inflation and downside risks to growth in light of the Iran conflict. The tone at the time was measured, reflecting uncertainty around the scale and persistence of the energy shock.

Events are Moving Quickly

Yet as the Iranian regime demonstrates unexpected resilience and maintains its blockade of the Strait of Hormuz, expectations have shifted towards a more prolonged disruption—driving ECB President Christine Lagarde to shift to a markedly more hawkish stance in the days following the meeting. The Bank, she emphasised, stands ready to act decisively to safeguard its inflation target, even if that means raising rates as soon as the April meeting.

Markets have taken note. Expectations have shifted towards two, potentially three, rate hikes later in 2026, lending some support to the euro after its earlier decline. Notably, the ECB arguably has more room to tighten than its peers without negatively affecting growth, given that its easing cycle concluded earlier and policy rates remain relatively lower than in the US and UK. A narrowing of rate differentials could therefore become a supportive factor for the currency.

The ECB Has More Room to Raise Rates

However, this is not a straightforward replay of 2022. Inflationary pressures are emerging from a weaker starting point, and the labour market is less overheated. The ECB’s challenge lies in managing expectations: with memories of the previous cost-of-living crisis still vivid, there is a risk that inflation psychology could shift rapidly and become entrenched. Preventing such a shift may require early and credible policy action.

Fiscal Fault Lines

Beyond monetary policy, fiscal risks loom large. European sovereign bond markets are already grappling with elevated issuance and rising borrowing costs. Additional fiscal support to offset energy prices could further strain budgets, raising concerns about debt sustainability in some member states. While fiscal pressures are not unique to Europe, they remain a key vulnerability that investors will monitor closely.

Geopolitics and Transatlantic Tensions

Geopolitics adds another layer of uncertainty. Relations with the US remain fragile, with trade tensions and policy unpredictability continuing to cloud the outlook. While progress on a transatlantic trade agreement offers some reassurance, ongoing frictions—exacerbated by Europe’s stance on the Iran conflict—leave scope for further diplomatic strains. Any escalation could weigh on investor sentiment towards euro-denominated assets.

Bondford’s Outlook

Bloomberg consensus forecasts point to a modest appreciation of the euro against both the dollar and the pound over the next 12 months, underpinned by expectations of relative policy support and some stabilisation in the Eurozone outlook. However, beneath this headline view lies a notable divergence in expectations—particularly against the dollar, where individual forecasts are far more dispersed, with a meaningful share still anticipating euro weakness. This contrasts with a more consistent bias towards euro gains against the pound, suggesting greater conviction in that cross. Taken together, this dispersion highlights the unusually high degree of uncertainty surrounding the euro’s trajectory, setting the stage for a range of potential outcomes depending on how key risks evolve:

• Prolonged Disruption - If the conflict in Iran and resultant energy supply disruptions persist, the Eurozone could face a renewed stagflationary shock, forcing the ECB into a difficult trade-off. Fiscal strains and weaker investor confidence could keep the euro under pressure, even if monetary policy tightens.

• Gradual Stabilisation - A partial easing of tensions, combined with stabilising energy markets, would allow the ECB to keep policy steady. Growth may remain subdued, but avoiding a severe downturn would support capital inflows. Narrowing rate differentials as others cut could provide a modest euro tailwind.

• Rapid Resolution - A swift de-escalation in the Middle East and a cooling in energy prices would significantly improve the Eurozone’s terms of trade and growth outlook. This could trigger a stronger rebound in the euro, particularly if accompanied by improved global risk sentiment.

Across all scenarios, the euro’s trajectory will hinge on the interplay between energy markets, central bank policy, and fiscal credibility.

Summary

The euro’s fate will be forged less by policy intent and more by energy reality—leaving it poised to recover if tensions ease, but vulnerable for as long as the shock endures.

Pound Outlook: Growth Risks Meet an Inflation Shock

A Currency Already Under Pressure

Sterling was already on the back foot before the Iran conflict. Softer GDP prints, cooling labour market conditions, and declining business and consumer sentiment had triggered a rapid repricing in rate expectations, with markets shifting their view from a prolonged pause to a roughly 90% chance of a March cut and further easing into 2026. By the time geopolitics took centre stage at the end of February, the narrative around the pound had already turned decisively more cautious.

The Iran Shock Changes the Equation

The outbreak of war in Iran, and the resulting surge in global energy prices, has fundamentally altered that trajectory. At its March meeting the Bank of England instead voted unanimously to hold interest rates steady, citing heightened uncertainty caused by the conflict. Having bought itself time, the Bank now faces a classic policy bind: whether to support a visibly slowing economy, which risks contraction if the shock intensifies, or to maintain its focus on inflation control, even at the cost of weaker growth. This is not a dilemma that can be easily resolved with conventional policy tools. Interest rates, blunt by nature, are ill-suited to address a supply-side shock of this kind, but may still be necessary from an optics standpoint. For now, policymakers can afford to wait and see how the conflict evolves, but that window may narrow quickly.

UK Natural Gas Prices Have Almost Doubled Since the Start of the War

Markets May Have Misread the Message

Communication from the Bank has added to the uncertainty. References to discussions around potential rate hikes at the March meeting — an unexpectedly hawkish turn —wrong-footed markets. Traders jumped on the language to price in tighter policy this year, providing a boost to sterling. Economists, by contrast, remain more circumspect. With policy already in restrictive territory and growth momentum fading, the bar for further tightening remains high. Crucially, this is not 2022. Then, economies were buoyed by the post-covid reopening surge and the release of pent-up demand. Today, those tailwinds are absent. The UK enters this shock from a position of relative fragility, making any additional tightening more economically painful and contentious, though not implausible if the conflict persists.

A Vulnerable Economy in the Firing Line

Recent forecast revisions underscore the UK’s exposure. The OECD has sharply downgraded the UK’s growth outlook for 2026—more than for any other G20 economy—while simultaneously raising its inflation projections. The underlying vulnerability is structural. The UK remains heavily exposed to imported energy costs, particularly natural gas, meaning rising input costs are likely to feed strongly into consumer prices. At the same time, households remain highly sensitive to price increases following the cost-of-living crisis of 2022. This combination raises the risk of a renewed wage-price spiral dynamic—precisely the kind of inflation persistence the Bank of England is seeking to avoid a repeat of.

UK Growth Was Dismal Even Before the Conflict

Fiscal Risks and Gilt Market Pressures

The impact of the energy shock is also being felt in UK fixed income markets. Gilt yields have risen to their highest levels since the global financial crisis, reflecting both expectations of tighter monetary policy and renewed concerns over fiscal sustainability. While higher yields would traditionally support a currency, the effect in this case is less clear cut. Rising borrowing costs, coupled with weak growth, risk undermining confidence in the UK’s fiscal position. There is also a growing risk of policy slippage. Political pressure to shield households from higher energy costs could prompt broad-based fiscal support measures, as was the case in 2022. While such interventions may be socially desirable, they would likely come at the cost of increased borrowing and reduced fiscal headroom.

Politics Adds Another Layer of Uncertainty

The political backdrop further complicates the outlook. With local elections approaching in May, the government faces mounting pressure in the polls. A weak electoral performance could reshape the internal dynamics of the ruling Labour party, shifting the balance of policy priorities. For markets, the key issue is credibility. Any perception that fiscal discipline is being subordinated to short-term political considerations would weigh on investor confidence—and, by extension, on sterling. In this environment, politics is not a sideshow. It is a central driver of market sentiment.

Bondford’s Outlook

Bloomberg consensus forecasts point to a nuanced outlook for sterling over the coming 12 months, with the currency expected to weaken against the euro while making modest gains against the US dollar. Beneath these headline projections, however, there is a notable divergence in views. Forecasts for sterling-dollar are widely dispersed, with a significant share still anticipating depreciation—underscoring the high degree of uncertainty surrounding the global backdrop and policy path. By contrast, expectations against the euro are more consistent, with a clearer bias towards sterling weakness. This split in views highlights the extent to which the pound’s trajectory remains contingent on how the current mix of geopolitical risk, energy prices, and domestic policy constraints ultimately evolves—an uncertainty that gives rise to a range of plausible outcomes in the months ahead:

• A short-lived disruption - would see energy prices stabilise, allowing inflation pressures to ease. In this scenario, the Bank could gradually pivot back towards supporting growth, and sterling may outperform current expectations as risk premia unwind.

• Gradual Stabilisation - A partial easing of tensions, combined with stabilising energy markets, would allow the ECB to keep policy steady. Growth may remain subdued, but avoiding a severe downturn would support capital inflows. Narrowing rate differentials as others cut could provide a modest euro tailwind.

• A severe escalation - would amplify these dynamics. A sharp rise in energy prices, combined with potential fiscal loosening and renewed gilt market stress, would create a more volatile environment. In such a scenario, downside risks to sterling would dominate.

Across all cases, one thing is clear: sterling is no longer being driven by conventional monetary policy cycles alone. Instead, it sits at the intersection of geopolitics, energy markets, and fiscal credibility.

Summary

Sterling is caught between a slowing domestic economy and a renewed inflation shock, leaving it highly exposed to external forces. Unless energy pressures ease quickly, the balance of risks points to further weakness - and a more volatile path ahead.

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