Market Brief: Iran whiplash forces markets into retreat

Hopes for a swift resolution to the war in the Middle East were shattered over the weekend when US-Iran peace talks collapsed and President Trump announced plans to blockade the Strait of Hormuz. Tehran reportedly baulked at several American red-line demands during Saturday's negotiations, refusing to dismantle uranium-enrichment facilities, halt funding for regional proxies, or guarantee free passage through the Strait. Within hours of Trump’s threat, US Central Command said American forces would begin enforcing the blockade "impartially against vessels of all nations entering or departing Iranian ports and coastal areas" from 10:00 am Eastern time today. Markets have reacted violently: Brent crude is up more than 8%* relative to Friday’s close, global yields are climbing, and equity futures are down as investors revert to hedging against a prolonged stagflationary shock.

The dollar is again outperforming its major peers, climbing against the pound, Swiss franc, yen, and Canadian dollar as the session unfolds. The opposition's landslide victory in yesterday's Hungarian election has done little to support the euro—even as it improves the outlook for European Union coherence and long-term stability—given that most investors remain wary of the downside risks from tighter monetary policy. Swaps traders are now pricing in 70 basis points in rate increases by year-end, up from 50 during last week's brief respite, and are assigning coin-toss odds to a move at this month's meeting.

The risks are substantial. If the president’s gambit succeeds in pressuring Tehran—which has continued shipping oil to buyers throughout the conflict—it could force an easing in hostilities and ultimately reopen the Strait. But it will also deepen the supply shortage facing global markets and may provoke wider retaliation against energy infrastructure across the region. Iran's leaders are likely to see the blockade as asymmetrically damaging to the world economy, given that the country shares land borders with 15 neighbours and has long experience of evading sanctions. Enforcement, meanwhile, would put American warships within striking distance of Iranian weapons systems and risk miscalculation—not only with China, which has continued to send flagged tankers through the Strait, but with allied nations too.

The economic and political toll on the United States is mounting. The biggest monthly jump in gas prices ever recorded lifted the consumer-price index to a year-on-year gain of 3.3% in March, and the University of Michigan's consumer-sentiment survey plunged to unprecedented lows in early April as households braced for worse to come. Polls show Americans turning against Trump's handling of the economy: his approval ratings are now lower than at any point in either of his terms, and lower than any under the Biden administration. JD Vance has become the most unpopular vice-president in modern history. Prediction markets are putting the odds of a Democratic sweep in November’s mid-terms—something considered all but unthinkable before the war began—at roughly 55%.

All of which is to say, there are reasons for optimism. The regime in Tehran, badly damaged but largely intact, is clearly angling for a compromise, and Trump, for his part, needs gas prices falling well before the mid-terms. The likeliest off-ramp—and the best base case for most market participants—is a face-saving interim agreement: Iran suspends enrichment beyond civilian-grade levels**, reins in its most provocative proxy operations, and eases its grip on shipping through the Strait, while America lifts selected sanctions and quietly shelves its maximalist demands. Such a deal would satisfy neither camp's hardliners, yet would uncork energy and commodity supplies and signal to rattled financial markets that the stagflationary worst may have passed.

Headlines from the Middle East will undoubtedly continue to overshadow fundamentals this week, but there are a number of events that should warrant attention for their currency-market implications. Tomorrow's US producer price update, followed by Wednesday's Beige Book survey, are both likely to show intensifying price pressures alongside rising uncertainty among American businesses, reinforcing stagflation fears. The euro area will publish an inflation update, with soaring energy costs expected to dominate, and China will release a raft of economic data, offering a window into the country's still largely-rhetorical rebalancing process. A number of central bank officials will also take to the speaking circuit, including the European Central Bank's Lagarde, the Bank of England's Bailey, and Fed policymakers Barr, Barkin, Bowman, Collins, Goolsbee, Miran, Williams, and Waller***. Most are expected, to varying degrees, to make the case for holding rates steady until the balance of inflation and labour market risks becomes clearer—but surprises are possible, and rate expectations could shift around changes in rhetorical nuances.

Taken in sum, risk sentiment will remain depressed for now, but there are reasons to think that the market trend will bend at the end. Hedgers should capitalise on tactical trading opportunities in the here-and-now, while anticipating an eventual (partial) normalisation in exchange rates.

*Yes, you—the detail-oriented reader—may notice my arbitrary shift here from “percent” to “%”. The style guide now in force is a Frankenstein's monster of British, American, and technical convention. As you can tell, I don’t have an editor. **This may sound a lot like the Joint Comprehensive Plan of Action (JCPOA) that was previously in force, but remember, that agreement was flawed in the sense that it had Obama’s signature on it.

***The IMF will also publish its latest World Economic Outlook and Global Financial Stability reports, giving nerds lots of new data to parse.

Market Overview

Notes: DXY: Dollar index, ON: Overnight movement, DMA: Daily Moving Average, Pivot points are calculated on a one-month basis, 3-month and 10-year spreads are against USD, Implied V.: implied at-the-money option volatility

Economic Calendar