Financial markets are suffering another round of tumult this morning after Israel launched dozens of air strikes against Iran, targeting its air defences, nuclear programme, and military leadership. As we go to print, it is clear that at least twenty top officials in Iran – including the military chief of staff, commander of the Revolutionary Guards, secretary of the National Security Council, and a number of nuclear scientists – have been killed, and that the Israeli Air Force has established air superiority over much of the country, paving the way for more intensive operations against nuclear enrichment infrastructure. Equity futures are setting up for a drop at the North American open, Treasury yields are down, and exchange rates associated with significant oil importers – the euro area, United Kingdom, Japan, and many of the biggest emerging markets – are on the defensive against a resurgent greenback.
Both of the major crude benchmarks – Brent and West Texas Intermediate – are paring their gains, but are up around 10 percent as investors brace for a potential disruption to shipping through the Strait of Hormuz. The waterway, which is dotted with Iranian islands, potential missile launch sites, and highly-mobile patrol boats, remains a critical chokepoint for global oil movement. Tehran has targeted tankers in the past – particularly during the Iran-Iraq War in the eighties – and has often threatened to do so again if it comes under attack.
Foreign exchange moves have been relatively modest in scale. Over the last decade, dozens of potentially dangerous tit-for-tat cycles in the Middle East have been de-escalated within days, conditioning currency traders to avoid taking big directional positions in response to alarming headlines out of the region. We suspect something similar will play out this time: Tehran remains deeply reliant on oil exports for foreign exchange, and aware of the damage that could be inflicted by the US, which maintains overwhelming military superiority in the region. US Secretary of State Marco Rubio last night said, “Israel took unilateral action against Iran. We are not involved in strikes against Iran,” before warning “Let me be clear: Iran should not target US interests or personnel”. But risks also can’t be ignored, with the extent of Israel’s assault raising the likelihood of a wider escalation.
The dollar is exhibiting classical safe-haven characteristics, suggesting that widely-broadcast fears of a lasting blow to its global dominance had gotten overwrought. The greenback leapt higher in the minutes after news of the Israeli assault hit the wires last night, and has outperformed its Swiss and Japanese counterparts in the hours since as investors have flocked toward the depth and liquidity offered by American financial markets – and as higher oil prices have reduced monetary easing expectations while setting the stage for a modest improvement in the US current account. We’re increasingly convinced that the currency’s underperformance this year has been primarily driven by a political uncertainty-driven re-rating in long-term growth expectations, not by any material change in short-term liquidity preferences.
The Canadian dollar is outperforming most of its advanced-economy brethren as rising crude prices drive buying interest. In the 21st century, correlations between the loonie and oil prices have tended to peak when the West Texas Intermediate benchmark has entered the $75 – $100 per barrel range, suggesting that investors expect capital expenditures in the Canadian energy sector to rise whenever selling prices exceed production breakevens by a significant margin. It’s not our base case, but a sustained rise in global energy costs could bring the loonie’s “petrocurrency” status back to life.
