Just Dreams

Last night saw a rocket attack
On assets, US, in Iraq
The oil price surged
While stocks were submerged
’neath selling by bulls who cut back

This morning, however, it seems
Concerns about war were just dreams
The losses reversed
As traders still thirst
For assets now priced at extremes

What a difference a day makes…or does it? Yesterday saw market participants’ initial evaluation of the threat of escalation in Iran/Iraq as limited with the result that early price action favoring haven assets reversed and most markets closed within a few basis points of Monday’s prices. The one exception to that rule was the dollar, which maintained its bid all day long, actually extending its gains late into the session. Other than the idea that international investors are buying dollars so they can buy US stocks, it is hard to come up with a short term rationale for the dollar’s recent strength. If anything, news this morning that the Fed’s balance sheet has grown even further, to $4.17 trillion, would imply that a weaker dollar is in the offing.

Of course, last night, shortly after the US markets closed, came the news that Iran fired a number of missiles at two different military bases in Iraq that are jointly used by the US and Iraqi militaries. There was a great deal of huffing and puffing from Iran, they announced the attacks themselves on Iranian TV, but in the end, they were nothing more than damp squibs. There was no material damage and no personnel killed, or even severely wounded. (And that is a good thing!) But at the time the news hit the tape, this outcome was not clear and risk assets plunged while haven assets soared. Thus, overnight saw gold trade up to $1610/oz, WTI rise to $65.65 (Brent to $71.75), Treasury yields fall to 1.74% and the yen rise to 107.65 (0.75%). But that price action, and the fear driving it, was quite short-lived. Once it became clear that the Iranian retaliation was completely ineffective, and they announced they were not interested in a major conflict, essentially all of that movement was reversed. So this morning we see gold at $1579/oz, WTI at $62.60, Treasury yields back to 1.82% and the yen actually net weaker on the day, at 108.70 (-0.25%).

This begs the question of how to consider this new potential risk going forward. The first rule of an exogenous market risk is the law of diminishing returns. In other words, even if there is another attack of some sort, you can be sure that the haven rally will be smaller and risk assets will not decline as much as the first time. And since this entire affair is occurring in a locale that, other than oil production, has almost no impact on the global economy, the impact is likely to be even smaller. Now I waved off oil production as though it is not important, but there is no question that the remarkable rise of US oil production has significantly altered the global politics of oil. When the Middle East was responsible for more than 50% of global production, OPEC ruled the roost, and anything that happened there had a global impact. But as oil production elsewhere in the world has grown and OPEC’s market share sinks below 40% (remember, the US is the world’s largest oil producer now), the impact of Middle Eastern conflagrations has fallen dramatically. The point is that short of a major attack by Iran on Saudi oil facilities or attempts to close the Persian Gulf, this situation has probably driven all the market excitement it is going to. In other words, we need to look elsewhere for market catalysts.

With that in mind, if we turn to the ongoing data releases, we find that German Factory Orders once again missed the mark, falling 6.5% Y/Y in November, highlighting that the industrial malaise in the engine of Europe continues. French Consumer Confidence fell more than expected, and Eurozone Confidence indices were almost uniformly worse than expected. It is difficult to look at this data and conclude that the situation in Europe is improving, at least yet. I guess, given this situation it should be no surprise that the euro is lower again this morning, down 0.3%, and actually trading at its lowest point this year (a little unfair, but the lowest level in two weeks). But the dollar’s strength is evident elsewhere in the G10 as the pound remains under pressure, -0.1% today and 0.45% this week. And the same is true pretty much throughout the space.

In the EMG bloc, the results have been a bit more mixed overnight with THB the worst performer (-0.5%) after comments from the central bank decrying the baht’s strength and implying they may do something about it. Remember, too, that APAC currencies, in general, saw weakness on the fear story, which dissipated after those markets closed. On the flip side, ZAR is the day’s biggest gainer, +0.6%, completely recouping its early-session Middle East related losses, as investors apparently focused on the incipient US-China trade deal and how it will benefit the global economy and South African interests.

On the US data front, yesterday saw a smaller than expected Trade Deficit and better than expected ISM data (55.0 vs. 54.5 exp). This morning we are awaiting the ADP Employment numbers (exp 160K) and Consumer Credit ($16.0B) this afternoon. We also hear from Fed Governor Lael Brainerd this morning, but it doesn’t appear as though she will focus on monetary policy as part of her discussion on the Community Reinvestment Act.

In the end, US data has continued to perform well, which thus far has been enough to offset the early impact of the Fed’s (not) QE. However, as the Fed balance sheet continues to grow, I continue to look for the dollar to decline throughout the year. As such, payables receivers should consider taking advantage of the dollar’s early year strength.

Good luck
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