Volatility Surges Amid Iran-Israel Conflict
Geopolitical tensions triggered a surge in demand for safe-haven assets yesterday. Gold, bonds, and currencies such as the USD, JPY, and CHF all rallied, while equities and risk-sensitive currencies like the GBP fell sharply. The VIX index, Wall Street’s so-called “fear gauge”, rose above its long-term average, indicating the likelihood of increased volatility ahead. Traders also noted that the VVIX – which measures the expected volatility of the VIX itself – has remained elevated above its long-term average for several months, signalling sustained anxiety in the markets.
Tensions in the Middle East have been simmering all year, with markets mostly focused on macroeconomic and monetary policy developments. However, a report that the US was actively preparing to support Israel against a potential ballistic missile attack prompted a flight to safety. This was swiftly followed by Iran launching around 200 missiles, raising the stakes for an Israeli retaliation. The extent of Israel’s response will determine how much additional geopolitical risk gets factored in by markets. Oil prices have already spiked 5% as the risk of a broader conflict rises. Given the speculative short positions in oil, this rally could gain momentum if these positions are unwound. Currencies of oil-exporting nations, such as NOK and CAD, appreciated as a result of surging oil prices, with GBP/CAD falling over 1% on the day.
Volatility has been subdued for much of the past two years, but the recent bouts over the last few months may be a warning that markets have entered a new regime – particularly with rising geopolitical risks and the US election looming. This scenario does not bode well for the risk-sensitive pound, which has already shed two cents from its 31-month high against the US dollar, reached just last week.
Mixed US Data Keeps 50 Basis Point Cut in Play
A slew of mixed US economic data released yesterday failed to alter the risk-off sentiment in financial markets, as the US Dollar Index climbed to its highest level in three weeks. Keeping a close eye on US data remains crucial, as markets continue to price in the likelihood of another 50 basis point interest rate cut by the Federal Reserve (Fed) before year-end.
US manufacturing activity contracted for the sixth consecutive month in September, reflecting weak orders and declining employment. The prices-paid index fell 5.7 points, the most since May 2023, to 48.3 – marking the first time this year that overall costs have decreased. The survey, however, was conducted prior to a strike at ports on the East and Gulf Coasts, the first in nearly 50 years, which could potentially drive up shipping costs and import prices going forward. Coupled with surging oil prices and supply chain disruptions, inflationary concerns could resurface. Furthermore, despite the weak employment index in the PMI survey, an uptick in job openings from the JOLTS report alleviated some concerns over the labour market. This complex backdrop could cause the Fed to reconsider the pace of its policy easing.
Earlier this week, Fed Chair Jerome Powell downplayed the likelihood of another large cut, suggesting that two quarter-point rate cuts by year-end were a base case. This led to a pullback in rate futures, which are now reflecting just 70 basis points of Fed cuts by the end of the year, down from over 75 basis points previously. Although yesterday’s data was overshadowed by escalating tensions in the Middle East, it makes Friday’s payrolls report a crucial factor in determining whether another significant cut will be on the table in November.
Eurozone Inflation Falls Below 2%
The euro depreciated amidst escalating geopolitical tensions and a preliminary report showing that Eurozone inflation has dropped below the ECB’s 2% target for the first time since 2021. European equities retreated, while bonds rallied as risk-averse sentiment took hold. The long-end of the German sovereign yield curve saw robust buying, leading to a bull flattening, with the 2-10 year spread narrowing to roughly 2.4 basis points, a one-week low.
In September, consumer prices increased by 1.8% year-on-year, down from 2.2% in the previous month, primarily due to a steep decline in energy costs. Energy prices continued to fall, and inflation in services slowed to 4% from 4.1%, although prices for food, alcohol, and tobacco edged up slightly. Core inflation also eased to 2.7% from 2.8%. Despite this moderation, the ECB anticipates that inflation will rise again later in 2024, as the sharp declines in energy prices fall out of the annual comparison. However, the recent drop in inflation below the ECB’s target has led investors to increase their expectations of rate cuts. An October rate cut is now nearly fully priced in (23 basis points), with market participants projecting further rate reductions through to May 2025. The 2-year Bund yield fell below 2% for the first time since 2020, and the implied terminal rate has dropped below 1.65%, hitting a multi-month low.
This dovish outlook has rekindled bearish sentiment towards the euro, pushing EUR/USD below the short-term support level of $1.11, marking a two-week low. The broader Euro index also declined, particularly against safe-haven currencies. Should this momentum persist, EUR/USD could slide further towards the 50-day moving average of $1.1036 in the near term.
Elsewhere, French Prime Minister Michel Barnier announced a two-year delay to the target for reducing the country’s budget deficit within the EU’s 3% limit, allowing more time to address public finances. Barnier warned that the deficit could exceed 6% this year. The market reacted negatively, with the yield on French 10-year bonds rising from an intraday low of 2.78%. The CAC 40 fell 1%, partly due to the deficit news, but also on headlines concerning an imminent Iranian attack on Israel. As a result, the 10-year OAT-Bund spread widened by 4 basis points, reaching 78 basis points.
