An exchange of missiles between Israel and Iran hogged the headlines over the weekend but left financial markets surprisingly unmoved. While gold and oil both rose on heightened regional tensions, the traditional safe havens of US Treasuries and the dollar hardly budged.
The dog that didn’t bark
Sometimes, what doesn’t happen is as important as what does. The US stock market fell by 1 per cent on Friday but ended the week just 0.35 per cent lower and looks likely to bounce back this week as investors see hostilities in the Middle East being contained. Meanwhile Treasury bonds remained range bound and the dollar hit a new three-year low as investors broke with the usual port in the storm of US assets at times of uncertainty.
Oil jumped more than 5 per cent over the weekend to around US$74 a barrel, reversing recent weakness, as investors took the view that hostilities between Israel and Iran will have a bigger impact on energy markets than the broader economy. Gold, too headed back towards its recent all-time high at just over US$3,400 an ounce.
But shares held onto their recent V-shaped rally from April’s ‘liberation day’ slump. Having fallen more than 20 per cent from February’s all-time high, US shares are back within a couple of percentage points of their peak. It’s an unusually strong rally and begs the question of whether the cyclical bull market that began in October 2022 is still intact. An equally plausible case can be made for a broad trading range between April’s low below 5,000 and today’s high of just over 6,000.
Earnings, the key driver of share prices in the long run, are at an interesting juncture. Stuck in a summer results lull, attention has shifted to earnings forecasts, which are easing back in the US while nudging ahead over here in Europe. That argues for a narrowing of the valuation gap on either side of the Atlantic and suggests that the ongoing rotation out of US markets and into the rest of the world, could have further to go.
Bonds meanwhile are range-bound with yields caught in a two-way pull between flat to lower interest rates on the one-hand and a rising term premium on the other. The term premium refers to the extra yield investors demand to compensate them for the inflation and default risks of lending for longer periods of time. At 4.4 per cent, 10-year US Treasury yields are caught between the 3.5 per cent or so that interest rate expectations might imply and the 5.5 per cent that the long-term premium might suggest.
Central bank focus
The outlook for interest rates is back on the radar this week with central banks all around the world getting ready to announce policy decisions. The US Federal Reserve (Fed), the most widely watched, is expected to leave rates unchanged at between 4.25 per cent and 4.5 per cent as chair Jerome Powell resists pressure from the White House to cut rates more quickly.
The Fed is waiting to see what the impact of US tariffs will be on growth and inflation in the domestic economy. With inflation hovering just above target and the outlook for growth slightly improving there is little incentive for the bank to move yet and Goldman Sachs thinks there will be no reduction in the cost of borrowing before December.
In the UK, rates are also likely to stay unchanged this week although the Bank of England does look to be on a steady easing path with cuts happening every other month as the Bank weighs a weakening economy with still persistent inflation. The Bank of Japan is also likely on hold, although inflation is a growing concern. In Switzerland, by contrast, there’s speculation that interest rates could head back into negative territory as deflation rears its head on the back of a soaring Swiss currency.
