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

By Jamie McGeever

ORLANDO, Florida, June 16 (Reuters) - 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 U.S. 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%.

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

The U.S. 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% 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% 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 U.S. 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.

PAINED SMILE

The dollar has historically been one of the best hedges against short-term volatility sparked by geopolitical risk, behind gold and on a par with oil, according to research published last year by Joe Seydl, senior markets economist at JP Morgan Private Bank.

Indeed, a Journal of Monetary Economics paper from last year stated plainly, "The dollar is a safe-haven currency and appreciates when global risk goes up," a trend resulting from the "fundamental asymmetry in a global financial system centered around the dollar" built up over the course of several decades.

That latter part of that argument hasn't changed.

The dollar accounts for almost 60% of the world's $12 trillion FX reserves, with its nearest rival, the euro, accounting for around 20%. Almost two-thirds of global debt is denominated in dollars, and nearly 90% 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 U.S. 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.

(The opinions expressed here are those of the author, a columnist for Reuters)

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