European markets sell off

The dollar is on the rampage right now as a mix of safe haven flows and a reduced chance of Fed rate cuts make the greenback a formidable force in the FX space. EM currencies have crumpled overnight, leading to intervention in the EM FX space. The dollar is higher vs. the Indonesian Rupiah by nearly 2% since Friday, which led to officials in Indonesia intervening in the FX market to prop up their currency. The South Korean won is also lower by nearly 1.4% vs. the USD in the past few days. The Indian rupee is at a record low vs. the USD. The prospect of intervention to support EM currencies, is extremely high, which could boost volatility in the FX market. The elevated oil price combined with the strong dollar raises the specter of inflation in the emerging world. As we have said in previous notes, reduced expectations of rate cuts from the Fed is unlikely to break something in the US economy, but it could break something in the EM world.

Asian stock market weakness takes cue from US

Overnight, Asian stock markets tanked on the back of mixed China data, which does not bode well for future growth, heightened Iran/ Israel tensions, as Israel weighs up its response to Iran’s drone and missile attacks, and a surge in US government bond yields, which rose sharply on the back of stronger US retail sales data on Monday. The 2-year yield tested the 5% level, however, it backed away from that level late on Monday. Safe haven flows on Tuesday could boost Treasuries and weigh on yields later today.

Israel/ Iran risks mount

Elsewhere, the initial muted response to Iran’s drone and missile attack on Israel has shifted. The market is back to being worried about the consequences. The brent crude oil price is back above $90 per barrel and is higher by 0.2% so far on Tuesday. The gold price made another record high on Monday at $2,383. It is lower on Tuesday, however, the recent surge in the gold price has been driven by sovereign and central bank buying, while flows into gold ETF’s have bene negative. With increased geopolitical risk, this could turn positive, and we may see flows into gold ETF’s start to rise again. If this happens, then the price of gold could move higher towards $2,500 per ounce.

A trifecta of risks for financial markets

Overall, there is a trifecta of risks for financial markets to digest on Tuesday: 1, a greater chance of a retaliatory strike by Israel on Iran, 2, the chance of the next move from the Fed being a rate hike not a cut and 3, a weakened China and more volatility in the FX space. This is why European stock markets have opened deeply in the red with the FTSE 100 down more than 1.2%.