Market Brief: Middle East Turmoil Keeps Markets In Risk-Off Mode

Fear levels are subsiding across global financial markets after Iran launched at least 180 ballistic missiles at Israel yesterday without inflicting large numbers of casualties or causing significant damage to infrastructure. Oil prices remain elevated, Treasuries are in demand, and the dollar is holding its gains after the attack triggered a flight to safety - but trading ranges are narrowing, and price action could easily reverse if the geopolitical escalatory cycle shows signs of slowing in the days ahead.

The threat of a retaliatory attack on Iranian oil infrastructure could keep prices somewhat elevated, but the risk of a sustained safe-haven bid for the dollar owing to an energy-related geopolitical shock from the Middle East remains low. Global crude demand growth is still decelerating as advanced economies curtail consumption and China’s appetite for raw materials slows. The OPEC+ group of exporting countries is sitting on high levels of spare capacity, and supply from non-members is outpacing demand. The world’s largest consumer - the United States - has become essentially self-sufficient. And the United States has parked enough military hardware in the region to make a shutdown of the Strait of Hormuz a deeply-unpalatable option for an Iranian regime dependent on illicit exports.

The Canadian dollar is acting like a petrocurrency once again, but we don’t think this will last. The loonie jumped in line with crude prices during yesterday’s session, and is holding its gains today, making it - and the Swiss franc - the only rival to the dollar over the last 24 hours. This fits a long-standing pattern in which oil price shocks are translated into currency market reactions through a muscle-memory process on trading floors, but doesn’t reflect a changed fundamental backdrop. The US is itself now a major energy producer, meaning that the greenback no longer exhibits a negative correlation with oil prices, the Canadian energy sector is no longer the recipient of massive inward investment, and Canada’s economic fundamentals remain consistent with a monetary easing trajectory that matches - and even exceeds - the Federal Reserve’s. Gravity might soon reassert itself.

And there are other factors powering the dollar higher.

The euro is licking its wounds after inflation fell below the European Central Bank’s 2-percent target for the first time since mid-2021, bolstering odds on another rate cut at this month’s policy meeting. Eurostat’s all-items price basket rose just 1.8 percent in the common currency bloc in the year to September, down from 2.2 percent in August as energy prices tumbled. The core measure eased to 2.7 percent, with lacklustre demand conditions helping to offset stubbornly-elevated wage growth in lowering price pressures. Earlier in the week, President Christine Lagarde hinted at an imminent rate cut, saying, “Inflation might temporarily increase in the fourth quarter of this year as previous sharp falls in energy prices drop out of the annual rates, but the latest developments strengthen our confidence that inflation will return to target in a timely manner,” noting that officials “will take that into account in our next monetary policy meeting in October”. Investors now think the likelihood of a move is around 94 percent, up from 55 percent just after the central bank’s September decision.

Although a slowdown is clearly underway, incoming data releases are not conclusively pointing to an imminent recession. The Bureau of Labor Statistics yesterday said that the hires rate fell to 3.3 percent in August and the quits rate - a reflection of worker confidence - slumped, but layoffs also fell, and job openings climbed. The Institute of Supply Management separately reported a softening in employment and prices paid by manufacturers in September, even as overall activity levels held steady and the volume of new orders climbed, setting the stage for a recovery in coming months.

Strike action could lift inflation expectations. Beyond snarling logistics networks and slowing the flow of goods into North America, widely-publicised job actions by dockworker unions at major ports on the US East and Gulf Coasts could give businesses another opportunity to pass along price increases without triggering consumer revolts - a phenomena dubbed “excuseflation” on the Bloomberg Odd Lots podcast last year. Inflation breakevens - which measure expectations for price growth over specific time horizons - are already pushing higher, and further increases could complicate the Fed’s policy path.

Fed officials are keeping their options open. In comments on Monday, Federal Reserve Chair Jerome Powell pushed back against overwrought easing expectations, saying “Overall, the economy is in solid shape; we intend to use our tools to keep it there … this is not a committee that feels like it’s in a hurry to cut rates quickly,” and warning “We are not on any preset course”. Markets are putting 37-percent odds on a second outsized cut at next month’s meeting, down from 55 percent a week ago.

The stakes remain high ahead of Friday’s non-farm payrolls report. If job creation slows to less than 150,000 and the unemployment rate resumes its upward trajectory, futures-implied odds on a half-percentage-point rate cut at the Fed’s November meeting will climb back above the 50-percent threshold, and the dollar will lose altitude. If, on the other hand, labour markets show signs of recovering, the greenback could snap higher, forcing an adjustment across global currency markets as easing expectations are pulled back. Data in the next two days - particularly this morning's ADP number and tomorrow's jobless claims print - will help determine market positioning, but it is Friday's release that carries the potential for driving the heaviest volumes and extending currency market trading ranges. As always in the run-up to an event risk of this magnitude, corporate hedgers would be wise to consider putting automated limit orders - bids and stop losses - in place beforehand.

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