This Changes Everything

By Benjamin Picton and Michael Every of Rabobank

Markets were moving quickly on Friday as conjecture swirled over the selection of a new Prime Minister in Japan. USDJPY rallied all the way up to 146.49 on speculation that interest rate dove Sanae Takaichi was poised to secure the premiership, but then dumped more than four big-figures before the close after news broke that principal rival (and supporter of BOJ policy normalization) Ishiba had won majority backing in a runoff vote.

The Nikkei stock index notes its displeasure this morning by selling off more than 4% at time of writing and Bitcoin is also lower. That stands in stark contrast to equities in China and Hong Kong, which are surging again as excitement over the China stimulus bazooka continues to buoy markets. Not to be outdone, SGX iron ore futures are up more than 8% this morning on the hopes that curbs to home construction in regional cities will be relaxed, although that seems to be at odds with the Chinese Politburo’s stated goal of limiting new housing development until the current oversupply can be worked through.

US Treasury yields were lower on Friday following the release of the August PCE inflation report. The headline PCE figure of 0.1% M-o-M was one-tenth better than expected, as was the Year-on-Year figure of 2.2%. Core PCE was lower on a month-on-month basis, while the super core services ex-housing measure rose slightly on a year-on-year basis. 2-year Treasury yields chose to accentuate the positive and fell ~7bps to 3.56%. 10-year yields were down by ~4bps, continuing the curve steepening theme that has now been in place since mid-2023. Meanwhile, Canadian GDP surprised to the upside in July to continue a recent run of improved year-on-year growth readings in the monthly national accounts series.

The softer tone in yields was helped along during the European session by soft CPI figures for Spain and France. Surveyed economists were expecting a figure of 1.9% Year-on-Year for each country, but the actual number came out at 1.5%. Market pricing on a possible October ECB rate cut shifted from a touch over 60% to more than 80% following the release of the inflation reports. Inflation for Germany and Italy due out today should firm up market expectations on the ECB’s likely actions in October.

While markets were busy reading the tea leaves on what it might mean for PCE to over/undershoot by a tenth of a percentage point, world changing events were taking place in the Middle East.

Global Strategist Michael Every writes:

The Middle East has seen exploding pagers and now exploding paradigms. On Friday, Israel killed the leadership of Shiite terror militia Hezbollah via a strike on its Beirut HQ: they, its comms, and thousands of its fighters are gone, and perhaps over 50% of its missile stocks, via more air strikes. Hezbollah has done little in response.

Israel also announced Hamas is ended as a fighting force, and just bombed the Houthis again, taking out port and oil facilities in Yemen. The clear message from Benjamin Netanyahu has been that nowhere in the Middle East is out of reach for Israel. In short, nearly a year since October 7, the most dangerous Iranian proxies in its “ring of fire” encircling Israel appear defanged and another is now vulnerable to air attacks, shifting regional and global political equations.

Iran has sworn revenge, but has few good choices available to it. Doing nothing clears the way for Israel to target Iran directly, and the experience of Hezbollah and the Houthis shows how. A ceasefire with Israel would be a major strategic defeat and radical change in the Islamic Republic’s entire philosophy. Attacking Israel directly would mean war, with the US involved.

Trying to split the US from Israel won’t work due to the election, and Trump will likely back Israel’s position. Attacking Israel/the West from different angles is an option, e.g., via terrorism or more Houthi-like groups. Then there is a defiant rush for a nuclear weapon: if that ambition is achieved, war with Israel and the US is assured. In the very worst case, Russia and China could back Iran directly or indirectly. The domino effect is always there as a tail risk.

Meanwhile, they can topple from both ends of the stack. With realpolitik getting results, Israel, the West and moderate Arab states could now try to swing Lebanon out of Iran’s orbit. Iran was rumoured to be sending troops to Beirut at one point over the weekend. That has not transpired, but points to Iranian concern at the potential total loss of Lebanon as satellite state.

At the same time, major victories, like crushing Hezbollah in two weeks, can be as contagious as major setbacks like October 7 or the US Afghanistan withdrawal. Western hawks might draw policy/paradigm arrows elsewhere, for example backing Ukraine on the long-range missile attacks into Russia that Moscow is warning would trigger its use of nukes.

Despite the Israeli strikes on Houthi oil infrastructure, and the possibility of similar strikes on oil assets located in Iran, Brent crude is only up 0.7% this morning to $72.49/bbl. This seems to be a continuation of markets pricing for perfection in all asset classes.

Markets are now imagining a scenario where Iran and its proxies can take loss after loss – without a corresponding rise in oil risk premia – alongside a scenario where China stimulus simultaneously works for equities, house prices and (some) commodities, but does not spike oil prices that have been falling in part due to… lack of demand in China!

The only explanation can be that Iran simply rolls over and allows decades of encirclement policy to fall apart (not likely, see above), while China stimulus is successful in pumping up fictitious capital but fails miserably at promoting real economic growth. This seems more likely, but it must be remembered that Xi himself is openly opposed to Western-style speculative financialization (especially in housing, which he says is “for living in”), and firmly in favor of increasing real production. How long will he let the stimulus bazooka fire before he makes another attempt at deleveraging the banking system?

The events of the weekend may have changed everything in a geopolitical sense, but one suspects that the laws of economics  still apply.