Is this the beginning of the end of the war?

There has been an abrupt change in the direction of markets this afternoon, with President Donald Trump hailing progress in talks with the Iranians to end the conflict in the Middle East. Stocks are higher, oil has fallen back to $101 a barrel for Brent crude and bonds are also in recovery mode, as markets price out the prospect of near term escalation in the conflict and instead price in the prospect of peace.

Will Iran play ball with Trump?

There is one problem, the Iranians have denied that any talks with the US took place. Donald Trump has said that airstrikes against Iranian assets are on pause for the next 5 days, which takes us to the weekend, what happens next is anyone’s guess.  

Rate hikes expectations moderate on Trump’s comments

The abrupt shift in tone from the President is leading to a flushing out of positions that were counting on a continuation of this conflict. European stocks are holding onto strong gains so far, and the S&P 500 and the Nasdaq are both pointing to gains of over 1.6% later this afternoon. The FTSE 100 is the outlier and is lagging its peers as oil majors come under pressure. The dollar is falling broadly, and the interest rate futures market is repricing interest rate probabilities once again. Earlier this morning the swaps market expected 4 rate hikes from the BOE this year, now it expects just over 2 hikes, all in about 1.5 hours!

What about the Strait of Hormuz?

This market is moving quickly, but it is worth going back to the facts. Is the Strait of Hormuz open? No, is oil and other energy supplies flowing freely around the world? No. While a de-escalation of this conflict is widely welcome, the market is moving based on one tweet from the US President and some comments to Fox Business that a deal with Iran could come in the next 5 days or sooner. However, the President has a capricious temperament, if there are more strikes from either side, or if the President is using this to buy time to move US troops into position to physically secure the Strait of Hormuz, it is hard to see this recovery rally lasting.

Oil price remains king

The oil price is probably the best gauge to measure market sentiment today. Brent crude is currently down nearly 10% on the day, and the oil price is hurtling back towards $100 per barrel. If this truly is an offramp, then we could see a move back towards $90 per barrel for Brent in the coming days. Even if there is progress to end this conflict, the oil price may not return to the $60 - $70 per barrel range for Brent as energy infrastructure in the Gulf will take time to come back on board.

One person who may be relieved that there is a potential step to ending this crisis is Rachel Reeves. At one point the surge in UK borrowing costs was poised to knock £8bn from her fiscal headroom. The 12 bp decline in the 2-year yield in the last 90 minutes is welcome respite, but yields are still higher by 90bps since the start of this conflict. The UK government will be hoping that the conflict continues to deescalate and a long term resolution found to stabilize UK borrowing costs. If the movement in UK yields in recent days had continued it could have led to a fiscal crisis.

What may happen next

If the President continues to double down on comments that the war is nearing its end and there are diplomatic steps to stop the bombing and hopefully, allow energy to flow freely around the world again, then risky assets will continue to rally along with bonds and gold, and the oil price should continue its retreat. If Trump’s version of events is denied by Iran, or if the missiles and drones continue to be dropped across the Gulf, then expect volatility to return. This is still a fluid situation and anything could happen.

Chart 1: Brent crude oil price

Source: XTB

Chart 2: UK 2-year bond yield, buoyant after Trump finds his off ramp

Source: XTB and Bloomberg