Pricing Predicaments of New Geopolitical Risk

The burgeoning Middle East conflict is proving tricky for markets. Everything has been going up lately – stocks, bitcoin, gold, all at record highs. But what impact is the conflict really having on day-to-day risk sentiment?

Oil spiked higher on Friday but dropped in the wake of the Iranian attack on Israel – you could say that the attack was big, but Tehran seems to be saying the matter is now closed. Gold prices also raced higher Friday morning before reverse-ferreting in the afternoon and holding losses this morning.

US yields are firmer but there has been a geopolitical premium to gold ever since Oct 7^th like never before. Bitcoin dived as the Middle East conflict heated up – down more than 14% from the Friday afternoon levels at one stage before paring losses a bit as Hong Kong approved a spot ETF.

The real flight to safety has been to the dollar – DXY futures highest since mid-November – but that’s probably more to do with higher Treasury yields and the emergence of monetary policy divergence among the major central banks. 

The Markets Await a Response

The next bit is really up to Israel. Where does the conflict go from here? Does it push oil prices up further? A widening of the Middle East conflict would surely add a premium for near-dated crude futures.

Gold is harder to fathom – geopolitical risk premium for sure as it has lately decoupled from real yields like the 10-year TIPS.

But what about the debt-debasement trade? Right now, the Israel situation is on the margins of the bigger stuff like the macroeconomic outlook, the Fed, earnings, etc. But what if the Middle East conflict does go big?

Risk-Off Tepid for Now

Stock markets are mixed this morning with the FTSE 100 declining half a per cent on weaker crude prices hitting the oil majors (about 20 points scrubbed off the index by Shell and BP), but mainland European bourses are broadly higher. Wall Street closed down quite hard on Friday, with the S&P 500 down almost 1.5% to cap the worst week of 2024.

There was a definite risk-off sentiment move on Friday, but this is rebounding a touch this morning with futures a bit firmer. 

Divergence or Dominance?

Last week we started to see central bank divergence – US inflation saw markets sharply price out a June cut, whilst the ECB seemed to be saying it will start to ease. But the question I wanted to ask was really whether we are in an era of fiscal dominance?

Will the fiscal taps continue to prevent CBs from taming inflation, and do they really care? This has a lot of implications for markets — and in particular for our assessment of whether the Fed and ECB really are starting to part ways.

Fiscal dominance refers to the possibility that the accumulation of government debt and continuing government deficits can produce increases in inflation that “dominate” central bank intentions to keep inflation low.

With the US adding about $1 trillion in debt every 100 days, it’s hard to see how the Fed can stay the course to tame inflation properly. Tacit acceptance of higher inflation is the price of financing everything from foreign wars to “domestic bliss.” Longer term that is going to be the case for Europe as much as the US. In the short-term at least, markets see divergence.

3% - The Emperor's New Clothes?

I have long argued that we are in a new inflationary paradigm – 3% is the new 2%. Running a 6% budget deficit a decade out with full employment, as the US is doing now, is bound to be inflationary.

Fiscal deficits in the US are powering stock markets and growth – i.e. fiscal dominance, which explains why inflation is persistent, growth continues, long yields are higher, and stocks don’t care.

But rising deficits are now being driven by interest expenses which don’t get fed back into the real economy like primary deficits do. Rising debt interest will reduce the fiscal impetus to growth despite its size – markets will be sensitive to the changes even if the absolute level is BIG.

So, if there is fiscal dominance right now (and it’s hard to see how financial conditions are so easy after so many hikes without assuming it’s playing a pretty big part) it may become a lot less dominant over time, which may make taming inflation a lot easier, and therefore make it an easier decision for the Fed to be cutting. 

The truth is I don’t know. Economic forecasts are always a bit of a fool’s errand. The market has decided to price out a June cut by the Fed whilst sticking to the view that the ECB will cut then. Overall, if global central banks are starting to diverge from the Fed, this can offer further support to the USD – however this may not fully materialise until we actually get some cuts.

Lower potential growth in the UK and Europe may be more inflationary, but demand is also lower. The growth outlook is less impressive, and I think they are clearly on course to cut. The question is whether the Fed has its blinkers on and plans to cut despite inflation. 

Elsewhere in the Markets

Meanwhile, keep an eye on Tesla shares with reports the company could be about to announce major layoffs. Not a good story for the stock which is down 30% year-to-date already. 

Later today we have US retail sales figures and the Empire State manufacturing index.

Elsewhere, the Japanese yen keeps screaming lower – time for intervention? I really think so.

Oil is down about 1% this morning, extending a typical bull flag — though we could see $82.50 area first. 

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