Trading Day-Truce hopes spark rebound
Optimism that a truce will be reached appears to be stronger in equity markets than elsewhere. Gold gave back Friday's gains but not before hitting $3,451 an ounce, a level last reached when it clocked a record high on April 17, and in volatile trade oil settled 1.7% lower, having surged more than 7% on Friday.
Perhaps equity investors have it right. The oil price has less of a bearing on global growth or asset prices than it used to, and markets have been pretty resilient to Middle East conflicts in recent years, with selloffs proving to be shallow and short-lived.
Unless there is a real adverse oil price shock, it will probably be a similar story this time around, although spiking inflation would be problematic for central banks.
Economists at Oxford Economics sketch out an extreme scenario where the closure of the Strait of Hormuz pushes oil up to $130 a barrel, which could lift U.S. CPI inflation to almost 6%. Oil is nowhere near that yet though.
As Deutsche Bank's Henry Allen notes, perhaps the story of the year is how resilient stock markets have been in the face of myriad large shocks - DeepSeek's emergence casting doubt over U.S. tech valuations; Europe's fiscal regime shift triggering the biggest daily jump in German yields since 1990; the U.S. losing its triple-A credit rating; Trump's tariffs and the S&P 500's fifth-biggest two-day fall since World War Two.
And yet here we are, with world stocks at all-time highs.
Aside from geopolitics, the focus for investors this week will mostly revolve around central banks. The Bank of Japan will deliver its policy decision on Tuesday, and economists expect it to hold off from raising rates again due to the uncertainty around U.S. tariffs.
Later this week we have decisions from Indonesia, Brazil, Switzerland, Sweden, Norway, Britain and the U.S. Federal Reserve.
Israel-Iran conflict highlights dollar's tarnished safe-haven appeal
A dramatic spike in the potential for all-out war between Israel and Iran would typically be expected to spark an immediate and strong rally in the U.S. dollar, with investors seeking the safety and liquidity of the world's reserve currency.
That didn't happen on Friday.
The dollar's response to Israel's strikes on Iranian nuclear facilities and military commanders, followed by Tehran's initial threats and retaliation, was pretty feeble. The dollar index, a measure of the currency's value against a basket of major peers, ended the day up only around 0.25%.
To be sure, the dollar fared better than U.S. stocks or Treasuries, which both fell sharply on Friday. But with oil surging over 7% and gold up a solid 1.5%, a strong 'flight to quality' flow would have lifted the dollar more than a quarter of one percent.
The U.S. currency's move was particularly weak given the dollar's starting point on Friday. It was at a three-and-a-half year low, having depreciated 10% year to date, with sentiment and positioning heavily bearish. Yet a significant geopolitical shock generated barely a knee-jerk bounce.
For comparison, the dollar rose more than 2% in both the first week of the 2006 Israel-Lebanon War and in the week following Israel's invasion of Southern Lebanon last year.
The dollar's weak response to this latest Middle East conflict supports the narrative that investors are now reassessing their high exposure to dollars, in light of some of the unorthodox policies put forward by U.S. President Donald Trump in recent months.
The dollar was down slightly early on Monday, and gold and oil were giving back some of Friday's gains too, as markets regained a foothold at the start of a busy week packed with key central bank meetings.
PAINED SMILE
The dollar has historically been one of the best hedges against short-term volatility sparked by geopolitical risk, behind gold and on a par with oil, according to research published last year by Joe Seydl, senior markets economist at JP Morgan Private Bank.
Indeed, a Journal of Monetary Economics paper from last year stated plainly, "The dollar is a safe-haven currency and appreciates when global risk goes up," a trend resulting from the "fundamental asymmetry in a global financial system centered around the dollar" built up over the course of several decades.
That latter part of that argument hasn't changed.
The dollar accounts for almost 60% of the world's $12 trillion FX reserves, with its nearest rival, the euro, accounting for around 20%. Almost two-thirds of global debt is denominated in dollars, and nearly 90% of all FX transactions around the world have the greenback on one side of the trade.
That means traders, financial institutions, businesses, consumers and governments still need to be more exposed to dollars than any other currency, even if they question the direction of current U.S. policy.
However, the dollar's downside 'structural' risks are growing, analysts at Westpac noted on Sunday, as concern over Washington's fiscal health and policy uncertainty erode the dollar's 'safe-haven identity'. Investors are now looking to hedge their large dollar exposure more than ever.
If this dampens their instinctive demand for dollars in periods of sudden geopolitical tension, uncertainty and volatility, then the so-called 'dollar smile' theory could be challenged.
This 'smile' is the idea that the dollar appreciates in periods of financial market stress as well as in 'risk on' periods of strong global growth and investor optimism, but sags in between. This idea was first outlined over 20 years ago by then currency analyst and now hedge fund manager Stephen Jen.
If the Israel-Iran conflict continues to escalate, that dollar smile could get rather lopsided.
What could move markets tomorrow?
* Israel-Iran conflict * Bank of Japan decision and guidance * South Korea trade (May) * Germany ZEW investor sentiment survey (June) * U.S. retail sales (May) * U.S. import prices (May) * U.S. industrial production (May) * U.S. 5-year TIPS note auction * Bank of Canada minutes * Headlines from G7 summit in Canada
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Opinions expressed are those of the author. They do not reflect the views of Reuters News, which, under the Trust Principles, is committed to integrity, independence, and freedom from bias.
(By Jamie McGeever; Editing by Nia Williams)
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