Markets: Middle East Tension and Less Fed Hawkishness

The human tragedy for all the families affected by the Israel/Hamas war is uppermost in people minds and they are in our thoughts at this terrible time. For markets, the Israel/Hamas war is fuelling Middle East tensions, with the traditional flight to quality bid for U.S. Treasuries. Less hawkish Fed speakers have also eased the pessimism in fixed income.

Figure 1: 10yr U.S. Treasury Yield (%) 

Source: Datastream/Continuum Economics 

The primary market focus is on how the situation in the Middle East develops. The political situation in Israel makes it likely that some form of ground invasion of Gaza will occur in the coming weeks given the 100+ hostages taken by Hamas and the horrific civilian deaths in Israel during the Hamas attack. The last Gaza ground war in 2014 is being seen as a point of comparison, which given the tight proximity of Gaza would likely mean more civilian casualties. Military strategists are also watching to see whether any invasion is via the North (less aggressive) or North, North East and South East Gaza (aggressive). A further question is whether Hezbollah in Southern Lebanon (here) would then be drawn in to attack Israel or not, which could widen the war and cause more Middle East tensions. This will impact short-term sentiment in markets and will swing markets around.

However, the market reaction to the tragic war has been for riskier assets to improve for a number of reasons. Firstly, the decline in government bond yields has eased the climb in yields seen since the July FOMC meeting (Figure 1). This is a function of traditional safe haven flows, plus short-covering given the acute pessimism in the hedge fund and CTA community. It also reflects a sense that a government shutdown in November is less likely, as Congress will have to pass expenditure that includes military aid to Israel. However, the last two days have also seen a wide range of Fed officials not sounding hawkish after the stronger than expected U.S. employment report and actually not sounding as though momentum is towards a November 1 Fed rate hike. Part of the reason is that Fed officials are nervous that the rise in 10yr yields can tighten financial conditions and reduce the need for a further hike. Additionally, it is also worth noting that inflation outcomes have been lower than expected, with average hourly earnings slowing to 4.2% Yr/Yr and Thursday’s CPI release and core inflation also likely to be key for Fed officials. With hedge funds still short, the squeeze on U.S. Treasuries could continue short-term.

Secondly, risk sensitive markets have taken the view that the Israel/Hamas war will likely be the sole focus for Israel, given the large military operation required. They are also likely to be encouraged by the Biden administration desire to avoid a wider conflict. This suggests the lasting impact on oil and the global economy will be small. However, the situation is fluid and it is not only Hezbollah that needs to be watched. Iran opposes Israel/Saudi Arabia normalisation for many reasons and could want to fuel a wider conflict. Russia could also try to fuel a wider conflict, as it splits U.S. attention away from Ukraine. Equity markets could still be in for a choppy Q4 at a time when the U.S. equity market is overvalued (here). 

Returning to the question of U.S. Treasuries, we are revising up our end 2023 10yr yield forecast from 4.25% to 4.45%. This reflects the inconsistency between a soft landing narrative and an inverted yield curve. U.S. Q3 GDP will likely be circa 4.5%, before slowing to around 1.0% in Q4. Additionally, the reality of heavy supply will remain, both due to the large budget deficit and the Fed ongoing rundown of U.S. Treasury securities by up to $60bln per month.