Dollar rallies as threat of wider Mid East war grows

The dollar has gained as markets fear the war with Iran will spread, the euro is now trading back at $1.1520 – have been below $1.15 for a time – while sterling is trading just above $1.3450. The single currency is up a little on sterling, to 85.5p. The Middle East conflict appears to be building with President Trump demanding Iran’s ‘unconditional surrender’ with speculation mounting the US is going to join Israel in directly attacking Iran. That speculation saw equities fall again while oil prices rose. This ratcheting up of geopolitical tensions over the past number of days is going to drive market volatility in the short term where we could see sharp moves one way or the another on both rumour and speculation as well as hard news and data.

While in times of turmoil investors should seek the safe haven of fixed income, there has been limited movement in bond pricing. In fact, the trend has seen yields tick up slightly rather than down as investors fear that the conflict will impact energy prices, and a sustained increase in oil prices will re-ignite inflation causing central banks to halt potential rate cuts, or indeed tighten policy. That has seen 10-year bund yields tick up to 2.53% yesterday (from 2.47% on Thursday) and 10-year US yields up a couple of bps from last Thursday.

Equities lost ground again, the major indices in the US and Europe seeing no upside to a wider war and more geopolitical conflict. The S&P fell 0.8% yesterday, taking it back down through 6000 while the Eurostoxx was down nearly another 1% and the FTSE down 0.5%. Upward pressure remains on oil prices with a barrel of Brent crude up over 5% on Tuesday, taking it right though $75/barrel again and trading closer to $77.

ZEW surveys show improving sentiment in Germany. The investor expectations index rose 22.3 points from May to 47.5, much higher than expected. Respondents were of the view that the fiscal policy measures announced by the new German administration combined with monetary stimulus from repeated interest cuts from the ECB will restart the moribund German economy boosting growth rates this year and next at the very least. The conflict in the Middle East may hit sentiment in the next reading, and longer should the war spread and/or be sustained, but this data indicated that investors believe the underlying German economy is now back on a growth path.

Retail sales in the US fell by 0.9% in May. This was primarily driven by a fall in car sales (excluding cars the dip was just 0.1%) but many retail sectors saw sales fall or stagnate last month. With signals from retailers that they are still working their way through stockpiles built up in advance of tariffs, sales could come under further downward pressure in the second half of the year as prices rise when new imports have tariffs applied, particularly for retailers sourcing consumer goods from China.

Looking to the day ahead, we get May’s final inflation print from the Euro Area and housing starts in the US. However, the main event will the FOMC meeting with the decision due at 7pm Irish time. This may be overshadowed by ongoing political events but the US central bank is very likely to stay on hold pointing to a solid labour market but rising downside risks from trade policy and now, potentially, geo-political tensions. Of key note will be the updated ‘dot plot’ from the Fed which will give the market a signal of when Fed members think rate cuts should resume based on their analysis of the situation at this point.