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Stephen Innes
The Shifting Tides Of Battle

With the dollar trading lower and yields steady, the initial knee-jerk reaction to the increase in geopolitical risk appears to be all but priced. However, the one thing that has surprised and possibly inspired equity investors to get back in the saddle was the lack of any significant sell-off in global stock markets.  

Equities don’t seem to fear much at the moment, indeed happy New Year from the Fed, who continue to offer up a cushy pillow of liquidity to soothe the market’s ills. 

Risk appetite returned with a vengeance which saw the S&P 500 posting its most significant intraday U-turn in three months as investors looked past concerns about escalating tension in the Middle East while focusing on the robust US economic data. The intraday bounce in stocks was pretty impressive after Markit US Services PMI was revised up to 52.8, better than forecasts for an unrevised 52.2.

There are some signs of firms reclaiming pricing power. According to Markit, service providers were able to increase their selling prices at a faster pace amid a quicker, albeit only modest, rise in cost burdens. New orders picked up for a second successive month. Foreign client demand also improved with service providers recording the first upturn in new business from abroad since July.

Further war rhetoric, retaliation, or innuendo could shift this interplay, but – for now, its the economic data that counts. Not to mention that oil sitting at $65 is not going to change the US consumer behavior, and if anything may stimulate some of the sidelined activity in US oil production. That would be a net positive for US stocks and the economy. 

But let’s face it, much of the pretzel logic around the latest Oil price narrative is so circa the 1990s and perhaps not fitting for the reality of today’s oil markets. There’s a deluge of spare capacity elsewhere in the world. Not to mention that shale oil production has completely changed the way we manage oil price shocks on a cross-asset basis. And frankly, this topic should form the new content of an introductory oil analyst 101 courses.

Oil Markets 

The US strike in Iraq last week offers up a speculators delight on the belief that Iran will need to muster up a sufficient response to mobilize local nationalist support. But it’s the great unknowns around what form of retaliation will transpire and the unlikelihood of de-escalation that should continue to support the higher risk premiums over the medium term 

However, let’s not forget the robustness of non-OPEC supply growth in 2020, combined with the restart of Neutral Zone production that adds to the ample spare capacity argument. These supplies could indeed be the ultimate top side limiter. 

While fading the move could make sense eventually, the problem I see is the oil price premium could linger since traders lack any quantified metric from which the market can assess and measure a price pullback. It was much easier to trade the fade during September when the Aramco facility was attacked as we were getting live streaming repair updates. Right now, the market is a bit of a guessing game. 

But questions remain as to how Iran will retaliate.

Sure, higher oil prices could be a thorn in Trump’s side during an election year, but the US is entirely oiled self-sufficient, and higher oil prices won’t hurt the economy. The US timed its attack to perfection from an oil-dependent data standpoint: In the week ending December 27, the US’s combined trade in oil and oil products showed the most significant net export on record of 1.7 MMB/d. So, Iran hitting out at oil Middle east oil production doesn’t necessarily make oil a high-value target to hurt the US economy. 

Not to mention China is exceptionally dependent on Gulf oil (46% of recent oil imports come from the Gulf region). And while the market’s worries about difference around US-China trade war, one area the two economic behemoths do see eye to eye on is to keep middle east oil flowing against any Iranian attempts to block oil chokepoints. The last thing Iran wants to do is bring China into the dispute. 

The US has also bolstered up oil infrastructure defenses in the region to almost impenetrable measures, so do you think Iran from a cost-benefit analysis would be willing to test those defenses in the face of a US 52-pronged Tomahawk retaliation?

Frankly, I’m not too fond of Monday morning quarterbacking (although it’s Tuesday) as its only an opinion and not a hard fact.  

And while no one should discount the risks packed into the higher oil price. But there’s an argument to be made that Iran will not provoke a more -conventional war with the US. Instead, prudence suggests Iran could administer its retaliatory muscle through more wisely targeted and less obvious methods.

Funny enough, I never listen to opinions when trading, but prudence always catches my attention. 

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Gold markets

Precious metals are giving back a lot of the gains made in thin Asian liquidity yesterday, with platinum leading the bunch. I would expect $1560/oz to offer up the first significant support in gold.

The leg higher in US stocks seems to be behind the subsequent drop off in demand for in fixed income, as US Treasury yields stabilized. Which is likely triggering the sell-off in gold

I don’t think the fixed income sell-off comes as too much of a surprise as the market remains in fade mode and is not about to easily roll over on the global growth trade provided the economic data remains secure. 

As for gold, with $15-20 setbacks the new intraday norm, look for volatility to remain elevated. 

Yesterday it was Chinese Banks that were chasing price action in a panicked fashion after local authorities released quotas early this year. Also, there was reportedly good demand for physical from these same banks, which is typical for January seasonality factors ahead of Chinese Lunar New Year. 

Lost in the fog of war is the fact that the Fed still very much counts for gold prices. Last week the Fed minutes conveyed the impression that the FOMC’s risk to their outlook had eased, although the bias was still to the downside. But overall, this statement does reduce the odds of a rate cut this year, which skews neutral to slightly negative for gold 

Currency markets 

While political tensions are pushing oil prices higher, these type of ‘supply shocks’ (as opposed to ‘demand shocks’) is usually not a great reason to chase oil exporter G-10 currencies higher given USD’s changing relationship with oil prices. In the past, oil shock risk and economic impacts might have been negative for the dollar, but now higher oil is no longer a negative for the US economy.

The Euro 

The Euro remains supported and continues to find buyers around the 200-day moving average and more positive PMI data this today could brighten the outlook again. The EU current account surplus puts the EUR in a strong position to weather a spike in oil prices, although it will likely be a short duration spike if one does happen that is.

Japanese Yen 

Selling USDJPY on upsurges in geopolitical tensions, whether it be Korea peninsula or the previous two years worth of middle east escalations, has not worked generally speaking. Sure, there the historical necessity that you must now Yen on risk aversion, but that desire typically fades after day ten, and now it’s fading after day four. Still, I think that also has to do with Japan’s negative economic disposition to higher oil prices.

The Ringgit 

The Ringgit market remains a bit tired. While Malaysia stands out among its regional peers as the only net exporter of oil and gas, any budgetary benefit from higher oil prices may be offset by the adverse effects on global demand. However, with the US dollar failing to regain its wrecking ball glory as the USD war haven demand has been mild, the Ringgit is under little threat.  And with global risk sentiment recovering even with higher oil prices, we should expect the Ringgit to trade in a more favorable light today. 

Asia oil importer currencies 

Rising tensions in the Middle East and higher oil prices pose significant economic risks to Asia, given its heavy reliance on that region for its oil imports. The oil importers with chronic trade deficits like India, Indonesia, the Philippines will be particularly vulnerable to oil price shocks

This article was written by Stephen Innes, Asia Pacific Market Strategist at AxiTrader

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