Market Brief: Markets turn cautious as geopolitical and valuation threats intensify

Risk sentiment is deteriorating across financial markets amid worsening geopolitical turmoil in the Middle East and a widening rout in technology-sector shares.

Another flareup in the Middle East conflict is keeping oil prices elevated and reigniting inflation concerns. The United States launched a sixth consecutive day of strikes against Iranian targets last night, with Tehran retaliating against facilities in Bahrain, Kuwait and Syria. Brent crude is trading just above $85 a barrel, up 15% this month. Shipping through the Strait of Hormuz has again ground to a standstill, and there are growing fears that Iran's proxies in Yemen could target traffic through the Bab el-Mandeb—a move that would threaten a second major chokepoint and disrupt another 14% of global trade.

Global stock markets are coming under sustained selling pressure as investors reassess the hyperbolic expectations embedded in artificial intelligence valuations, with a number of indices on track for their worst week since last year's ‘Liberation Day’ rout. Nervousness has been mounting for weeks, but an announcement from Moonshot, a Chinese start-up, that it has developed a model capable of rivalling far costlier offerings from Anthropic and OpenAI is fuelling fears the industry's vast infrastructure buildout may never earn the returns needed to justify its cost. Yesterday's drop in American markets has since rippled across time zones—Japan's Nikkei 225 tumbled 4%, China's CSI 300 shed 3.6%, and Taiwan's benchmark plunged more than 6% overnight—with futures pointing to the S&P 500 and Nasdaq 100 opening down 1% and 2% respectively. SpaceX, a bellwether for stretched valuations, is now trading below its listing price.

The dollar is consolidating and looks set to end the week on a slightly firmer footing as receding expectations for Federal Reserve rate increases are offset by renewed safe-haven demand. After relatively benign consumer and producer price data earlier in the week pointed to easing inflation pressures, futures markets are now pricing in roughly 26 basis points of Fed tightening by December, down from almost 40 a week ago. Treasury yields are falling as investors rotate out of highly leveraged positions elsewhere and seek the safety and liquidity of the world’s largest bond market.

But the greenback could prove more vulnerable than this price action suggests, given the American economy's enormous dependence on artificial intelligence investment. A sustained sell-off in the technology sector could hit growth through multiple channels at once: weaker data-centre construction and reduced spending on chips, servers, and software would mechanically lower gross domestic product growth; a pullback in global investor flows might erode the capital-account surplus that has been propping up the currency; diminished wealth effects could weigh on consumer spending; and tighter financial conditions would likely slow activity more broadly. The exceptionalism that has drawn capital into the United States is built, to a troubling degree, on a single trade. If that trade unwinds, the dollar's recent advance may unwind with it.

The Canadian dollar is on track to record the best performance among G10 currencies this week, beginning to correct from technically oversold conditions as short interest fades and traders target the 1.40 threshold. Next week's inflation update is expected to show headline prices falling in month-on-month terms, reflecting a drop in gasoline costs, while the core measures targeted by the Bank of Canada remain restrained — consistent with a lack of demand-led price pressures in the still-weak economy. But the release is unlikely to change the loonie's outlook materially, given that its direction has not been set by shifts in Canadian monetary policy expectations for some time, and that a soft inflation print will do little to alter the rate differentials that matter. Crude prices and the US dollar will remain in the driving seat.

The pound is trading near a one-year high against the euro on reports that Andy Burnham is likely to appoint Shabana Mahmood as chancellor once he takes over as prime minister next week. Little is known about Mahmood’s economic views, but the current home secretary is seen as right of centre and more fiscally conservative than her rivals for the role. The political risk discount embedded in gilt yields is easing, and traders are unwinding short bets on the currency, with still-overstretched positioning opening up the potential for a leg higher. Options markets remain more cautious, however, with the skew in risk reversals staying deeply negative—a sign that demand for hedges against a weaker pound has not fully abated even as the spot market rallies.

Traders are overwhelmingly convinced the European Central Bank will hold rates at next week's meeting, but the euro could move nonetheless. June's inflation data eased the pressure on policymakers to tighten immediately—headline prices fell to 2.8% year on year from 3.2%, the core reading dropped to 2.4% from 2.6%, and the closely watched services measure slipped to 3.2% from 3.5%—but a resumption in the US-Iran conflict has sent oil and natural gas benchmarks higher once again. This means messaging may matter more than the decision itself, with language on expected inflation passthrough and the balance of risks parsed closely for guidance on whether current market pricing—a hike in September followed by another in the early new year—remains justified.

Market Overview

Data as of 7:15 AM EDT

Notes: DXY: Dollar index, 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

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