The market’s reaction to global tensions may not follow the old script

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The good vibes circulating in the global markets are proving to be very difficult to change. Overnight, the burgeoning conflict in the Middle East has clearly gone from bad to worse. Iran launched a barrage of missiles at Israel — exactly the kind of escalation investors say they’ve been worried about for months — and yet the reaction in markets was nervous but muted.

Stocks in Europe and Asia fell slightly but were mostly flat in the morning after the attacks. Oil prices rose, but only enough to push Brent crude to around $75 a barrel – the highest in about a week. Gold prices, already doing well after gains of nearly 30% this year, failed to hit a new record high. And the dollar — usually a favorite bet in times of geopolitical strife — made unremarkable gains, adding about 1 percent against both the euro and a basket of major currencies this week.

“It’s a bit scary when you see Iran’s involvement,” said Björn Jesch, chief investment officer at German asset manager DWS. “But it was more or less the same reaction as the last time they sent missiles. The question is US involvement.”

This is, of course, the wild card, and few money managers would claim to have enough insight on this point to shift portfolios with any confidence in what the next step might be.

We may come to look back on this reaction as a moment of strange complacency or as one of sensible calm. For now, though, Jesch says he wouldn’t describe this as a clear “risk off” period — market parlance for “running for the hills.”

All of this tells us a lot about the sustaining power of US monetary policy, and also about the changing ways markets respond to bad news.

First, smart messages from the Federal Reserve continue to trickle down into global asset prices. The US central bank cut interest rates by an unusually large amount – half a percentage point – two weeks ago, but it clearly managed to convince investors that it did so because it could, not because he fears a recession. This combination of the rapid easing of monetary policy and the continued resilience of the US economy is pushing risk assets to their best points. Investors may still be a little optimistic about how many US interest rate cuts are coming in the next year or so, but the collective judgment of market participants is that none of the Israel news of the past few days is enough. gloomy, in cold macroeconomic terms, to overturn exuberance.

On the sidelines, last week’s multiple stimulus effort by the Chinese authorities, just ahead of a series of market holidays, is also helping the mood.

In the mix here, though, it looks like market shocks aren’t quite what they used to be, especially against the dollar, which generally sails higher in doom and gloom.

War, pestilence, recession, financial shocks – and all the other bad things in between – have historically been pretty consistent triggers for money to bounce against almost all other currencies, whether from developed or emerging economies. Sometimes this takes extreme forms – a ferocious rise in the dollar has been one of the defining features of the shock to markets since the outbreak of the Covid epidemic nearly five years ago.

Now, however, swap lines agreed by various central banks to ease the global flow of dollars in times of crisis help cushion the impact of shocks. And crucially, US rates have soared above much of the rest of the developed world over the past two years or so, soaking up global funds and encouraging companies around the world to retain earnings in dollars on a highly unusual scale. This changes how the dollar responds to fear and greed. Examples are already emerging. In the summer, for example, a violent selloff in stocks coincided with a fall, not a rise, in the dollar.

In the past, fear has been a constant trigger for investors and other market participants to pile in dollars, and it’s still hard to imagine it going away completely. But speculative dollar holdings built up from Covid are more likely to be unloaded than to continue accumulating in a shock now.

At the current point of market tension around Israel and Iran, the dollar’s modest rise is largely in line with other asset classes. If things deteriorate further, however, don’t expect them to necessarily stick to the old script.

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