Weekly focus – Geopolitics steals the spotlight again

Geopolitical developments in Middle East took centre stage in the markets this week. Despite the slightly optimistic tones of voices after the US-Iran talks ended in Geneva early this week, the US military buildup in the region has continued and the risk of a conflict is hanging in the air. Based on media reports, President Trump has not yet decided whether to attack, but if so, the attack could come soon.

Oil market has started to react to developments in Middle East. This week, Brent broke through USD 70 per barrel level. Unlike in early February, this time around higher oil prices are not driven by a weaker USD. On the contrary, the DXY index rose 1% this week. The fact that implied oil volatility is also up, suggests that this time the price move is primarily driven by a geopolitical risk premium.

In our view, the current market pricing broadly reflects a scenario where Iran's response to any US intervention would remain carefully calibrated - similar to what we saw last June. Thanks to excess supply, the oil market has some buffer against geopolitical shocks for as long as the shocks would be limited in scale and duration. Even limited disruptions in the Strait of Hormuz (SOH) would not devastate markets for as long as oil and gas flows would continue. And for now, tanker traffic seems to have returned to normal levels. That said, in the worst case, a complete closure of the SOH for several days could drive oil price above USD 100 per barrel.

The higher oil price has been one of the factors weighing on euro lately, as Europe's energy imports dependence remains one of its key vulnerabilities. This week, EUR/USD fell below the 1.18 mark. We still think the downside is temporary and now target EUR/USD at 1.25 in 12M.

On data front, focus was on euro area sentiment surveys this week. The German PMIs surprised on the upside, corroborating the story that the German industry is finally recovering. The manufacturing PMI exceeded the watershed 50 level for the first time since June 2022. The French PMI also topped expectations on the composite level, but manufacturing index disappointed by falling back below 50.

The speculation that ECB's President Lagarde would leave office before her term expires also received media attention this week. The rumours have not been confirmed, and in any case, we do not see this as a key market driver.

In the US, we have adjusted our Fed call. We still foresee terminal rate at 3.00-3.25% but have pushed the rate cuts further out. Recent data from the US has again painted a picture of a resilient economy, but while consensus has continued to upgrade GDP projections for this year, we are a bit cautious about whether private consumption can maintain its current strength. This week, we also saw how the economy is starting to rebalance with trade balance re-widening in December as imports volumes are starting to recover from abnormally low levels.

Next week's calendar looks rather empty with the main events being Trump's state of the union speech on Tuesday and EA flash HICP on Friday. Hence, it is more than likely that geopolitics will remain the main market driver.

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