Markets weigh risk of retaliation-cycle after Iran hits Israel

Financial markets will face the new week fretting about geopolitics with much riding on whether Iran’s unprecedented weekend strike on Israel triggers rounds of retaliation.

With investors already rattled by sticky inflation and the prospect of higher-for-longer interest rates, the escalation of the Middle East crisis is set to inject fresh volatility when trading resumes.

When Hamas attacked Israel in October, the biggest fear for many market participants was that Iran would ultimately be drawn into the fighting. Now as the conflict widens, many say oil could surpass US$100 a barrel and expect a flight to Treasuries, gold and the dollar, along with further stock market losses.

A spike in nerves may still be tempered by Iran’s statement that “the matter can be deemed concluded” and a report that US President Joe Biden told Israeli Prime Minister Benjamin Netanyahu that the US won’t support an Israeli counterattack against Iran.

“Investors’ natural reaction is to look for safe-haven assets in moments like this,” said Patrick Armstrong, chief investment officer at Plurimi Wealth LLP. “Reactions will be somewhat dependent on Israel’s response. If Israel does not escalate from here, it may provide an opportunity to buy risk assets at lower prices.”

Bitcoin gave an early insight into market sentiment. The token sank almost 9 per cent in the wake of the attacks on Saturday (Apr 13), only to rebound on Sunday and trade near the US$64,000 mark.

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Stock markets in Israel, Saudi Arabia and Qatar posted modest losses under thin trading volumes.

“Middle Eastern markets opened with relative calm following Iran’s attack, which was perceived as a measured retaliation, rather than an attempt at escalation,” said Emre Akcakmak, a senior consultant at East Capital in Dubai. “However, the market impact might extend beyond the Middle East due to secondary effects on oil and energy prices, potentially influencing the global inflation outlook.”

Investors will now weigh the risk of a strike and counter-strike cycle, with many looking to oil as a guide for how to respond. Brent crude is already up almost 20 per cent this year and trading north of US$90 a barrel.

While the conflict in the Middle East hasn’t yet had any impact on production, Red Sea attacks by Iran-backed Houthis in the Red Sea have disrupted shipping. Traders mostly fear a widening conflict could disrupt tanker shipments from the Persian Gulf through the Strait of Hormuz.

Worries about turmoil in the region have also been filtering through global markets. The S&P 500 is coming off its biggest weekly decline since October on the back of higher-than-expected inflation and disappointing bank earnings.

In the bond market, traders will be weighing the risk that more expensive energy bills may add to swirling inflation fears. While Treasuries tend to benefit in times of uncertainty, the threat of interest rates staying high could limit moves.

Meanwhile, gold has been on a tear, gaining 13 per cent this year to hit a record above US$2,400 an ounce. Investors have also sought the stability of the US dollar. An index of the currency rose 1.3 per cent last week, the best performance since late 2022.

Gonzalo Lardies, senior equities fund manager at Andbank, said: “A new environment of uncertainty is now opening up, but the market on Friday already partially priced in this situation, so if it does not get worse the impact should not be very high. The risk is if this situation escalates and there is contagion in the region.”

On Friday, US equities saw their worst day since January after reports that Israel was bracing for an attack by Iran on government targets.

The S&P 500 fell 1.5 per cent on Friday, with banks and chipmakers leading losses. The gauge posted its biggest weekly drop in 2024. Treasury 10-year yields sank seven basis points to 4.52 per cent. Andrew Brenner at NatAlliance Securities also cited “massive short covering” and rate locking before an expected flurry of debt issuance by banks after earnings.

Said Neil Shearing, chief economist at Capital Economics in London, on Sunday: “Our sense is that events in the Middle East will add to the reasons for the Fed to adopt a more cautious approach to rate cuts, but they won’t prevent it from cutting altogether. We expect the first move in September. And assuming that the energy prices don’t spiral over the next month or so, we think that both the ECB and BOE will cut in June.”

The dollar notched its best week since September 2022. Brent oil settled above US$90. Gold topped the US$2,400-an-ounce mark before erasing gains.

Treasuries rallied sharply on Friday, following the market’s worst two days since February, in which yields reached year-to-date highs after inflation readings savaged expectations for Federal Reserve interest-rate cuts this year. Two-year yields – which briefly topped 5 per cent this week – plunged on Friday.

Jose Torres at Interactive Brokers says the latest developments illustrate how investor sentiment and high equity valuations are vulnerable to geopolitical conflicts, persistent inflation and oil prices. 

“Investors have pushed back their expectations for the start of the Fed’s easing cycle – with geopolitics possibly replacing the Fed as one of the market’s top volatility influencers,” he noted. BLOOMBERG