Here Comes The Cavalry?

By Benjamin Picton of Rabobank

Here Comes The Cavalry?

The risk of imminent hot war between Israel and Iran seems to have dissipated for the time being. Israel on Friday delivered its promised response to the Iranian strike of the weekend before by hitting targets in Syria and the Iranian city of Isfahan. Reporting of the strikes has stressed that they were ‘modest’, while Israeli Minister of the Interior Ben Gvir tweeted “weak!” in Hebrew at the time of the attacks. The Israeli response appears to have been carefully calibrated to de-escalate, while also sending a message to Iran. Iran has played-down the Israeli attack, which suggests that the promised 10x escalation is not going to be immediately forthcoming.

According to the New York Times, the strike on an Iranian airbase outside Isfahan was designed to demonstrate to the Iranian regime that Israel had the capability to hit key Iranian infrastructure if it wanted to. The attack, reportedly using a sophisticated two-stage air to surface missile, damaged Russian-made air defence systems and, critically, landed adjacent to Iranian nuclear assets. The very clear message to Iran being that “we can hurt you if we want to.”

Following the attacks, initial strong rallies in gold and crude oil prices have receded, and both are trading well back from the highs. Gold is back below $2,400/oz, while Brent crude is well under the $90/bbl psychological level, and remains under selling pressure early this morning. Markets might have relaxed slightly, but we should be under no illusion that the conflict is over. Gideon Rachman opines in the FT over the weekend that Russia, Iran, North Korea and China constitute an “axis of adversaries” that are working together in opposition to the West. Indeed, that Iranian nuclear enrichment site outside of Isfahan utilizes Chinese-supplied reactor technology. Regular readers of this Daily will be unsurprised by claims of cooperation among autocratic states as our Global Strategist, Michael Every, has been pointing this out for several years now.

Equity markets on Friday seemed to be pricing the view that “it ain’t over yet”, although possibly for the wrong reasons. The NASDAQ fell by 2%, the S&P500 was down by 0.88% and market darling NVDA fell by 10% following unconfirmed rumours circulating on X that Stanley Druckenmiller has sold down his position.

There’s some logic to be found duration-sensitive equities being hurt most. The Treasuries curve has parallel-shifted 40bps higher since the end of March, despite the sighs of relief heard in dealing rooms on Friday once it became clear that war wasn’t about to break out. The 2-year Treasury is currently dealing on a yield of 5%; Janet Yellen and Co will be hoping that the 10-year doesn’t join it at that level.

Traders aren’t the only ones picking up on the meme of conflict being the new normal. The US House of Representatives came to agreement over the weekend on a $61bn aid bill for Ukraine, Israel and Taiwan. The bill will be debated in the Senate this week before being sent to Joe Biden’s desk for signing (assuming it clears the Senate). The prospect of fresh lethal aid will be welcomed by Ukrainian troops, who have been on the backfoot as shortages of arms, ammunition and manpower prevent them from challenging Russian air superiority, or counterattacking Russian positions.

Ukraine’s leadership will be hoping that the passage of the US aid bill will buy some time for the European military industrial complex to spool-up arms supplies. European aid had recently overtaken aid from the United States, but is more heavily skewed toward financial assistance (rather than armaments). The spectre of a second Trump presidency (and a consequent redirection of US arms and funding) looms large over the conflict in Ukraine. As described by this Daily previously, Emmanuel Macron sees the Ukraine war as vital to the security interests of the European Union, even to the extent that he has not explicitly ruled out deploying French troops in the defence of Ukraine.

Meanwhile, the Japan Times reports that Xi Jinping has ordered the largest reorganisation of China’s military since 2015. Special attention is paid to a reorganisation of China’s cyber and space capabilities into a new branch, in echoes of Donald Trump’s establishment of the US Space Force. With US GDP figures for March due to be released later this week, it will be interesting to see whether the economic and military heavyweight of the Western sphere can replicate the upside growth surprise that its main challenger posted just last week.

With yields having settled at a higher level despite the events of the last two weeks suggesting that ‘risk off’ might be the trade, could another US growth beat be the catalyst for 10y Treasury yields to make a stretch toward that 5% level?

If that proves to be the case, light a candle for the central bankers of the high beta FX world, and for USDJPY.