Geopolitics in Iraq to ensure a volatile week for investors

Macro Outlook

The emergence of a new geopolitical threat to stability (or lack there of) in the Middle East has resulted in a significant change of outlook for financial markets. Militant groups (with links to Al Qaeda) are threatening to take Iraq into civil war. This has big implications for Iraq’s oil production and oil prices have spiked higher – something that is not good for global growth. There has subsequently been a demand for the more safe haven assets such as precious metals, and the Japanese yen. Stock markets have also come under selling pressure. Previously, volatility had fallen to such an extent that the VIX Index (which measures volatility on index options for the S&P 500) had fallen to its lowest level since early 2007. This suggested traders had been avoiding using option strategies such as buying put options that would be able to hedge their long portfolios in the event of a market correction. As the market began to digest the situation in Iraq though, the VIX index increased sharply suggesting increased demand for protection once more. The VIX is a good gauge of how the market perceives risk and if the situation in Iraq persists, expect further sharp jumps in the market’s “fear” index.

Must watch out for: FOMC monetary policy decision

Impact: The Federal Open Market Committee meeting is not expected to deliver too many curve balls for the market this week. The expectation is that monetary policy will continue to run along the recent line of tapering asset purchases by a further $10bn, which would see the monthly purchase of Mortgage Backed Securities fall to $15bn for the month (from $20bn) and the purchase of Treasuries to $20bn (from $25bn). Interest will be taken in the press conference where trader will look for signs of an earlier tightening cycle which is currently pencilled in for mid 2015.

Foreign Exchange

The Dollar Index had a sharp fall last Thursday. Despite Sterling accounting for just over 10% of its weighting, hawkish comments from Mark Carney, Bank of England governor showed that the recent upside breakout on the Dollar Index will not be a smooth ride towards the January high of 81.3. In his Mansion House speech, Carney suggested that views on the Monetary Policy Committee were becoming balanced and that there could be a rate hike sooner than the market had been anticipating. Short-Sterling Interest Rate futures (the market’s interest rate predictor) moved sharply on Friday to price in the new expectation and now suggest that a rate hike in at least December is now almost nailed on, whilst also showing a tightening speed of 100 basis points up to December 2015. The Euro-Dollar STIRs (US interest rate futures) suggest June 2015 for the first rate hike (with again 100 basis points to June 2016). Sterling is on an earlier tightening cycle but at the same pace, suggesting that once the move is priced in, subsequent moves will then be data dependent. Now over to the FOMC to see if there will be any hawkish signals from the Fed which would counter the Sterling gains.

WATCH FOR: Sterling moves will be even more data dependent now, and a decline in CPI this week could take some steam out of the recent run. Dollar traders will be looking for hawkish FOMC minutes and better inflation data to drive the greenback higher.

Indices

The underperformance of the FTSE 100 remains something of a quandary for investors. As the European indices fell into the close on Friday amid concerns over Iraq, it was the FTSE 100 that took the biggest blow. Both Wall Street and the DAX have been busy breaking into new high ground in recent weeks, however the FTSE 100 has remained stubbornly camped underneath the resistance at 6895. One of the key factors has been the composition of the index, which is heavily weighted in sluggish mining stocks, banks and oil majors. Furthermore, around 70% of revenues are derived from overseas, so whilst the UK economy has been charging along at a fair old pace, stocks in the large cap index have been unable to take advantage of this sentiment. However this underperformance is likely to continue, at least against its European counterparts. The package of monetary easing measures engaged by the ECB, should help to drive Eurozone investment markets (and subsequently their indices) higher, whilst a rate tightening cycle is looming on the horizon for UK investors. Equity markets tend to perform much better in easier monetary conditions than tighter monetary conditions, so I would not expect the FTSE 100 to outperform the major bourses any time soon.

WATCH FOR: Investor sentiment seems to be reacting to the situation in Iraq for the time being and this is likely to drive equities in the coming week. Volatility should also be driven by the FOMC on Wednesday.

Other Assets: Commodities & Bonds

Oil prices spiked higher last week as geopolitical tensions escalated in Iraq. The spread of militant activity led by ISIS (Islamic State in Iraq) has the potential to disrupt oil supplies in one of the world’s largest oil producers. Furthermore, the prospect for US intervention (probably in the form of drone strikes) is increasing and could mean that we are just at the beginning of a civil war between the Sunni and Shia Muslims . Brent Crude has jumped around 4% in the past week and if markets begin to price in a significant escalation, there is the potential for sizeable upside. Commodities such as gold and silver have also risen on the flight to safety, but the oil price has been the main focus for investors.

Mark Carney’s hawkish comments have certainly had an impact on UK gilts. With the governor of the Bank of England bringing forward expectations of the beginning of the tightening cycle, investors sold 5 and 10 year gilts. This pushed the yield on the UK 10 Year Gilt to its highest level since 11th March, and now almost double the yield of German Bunds.

WATCH FOR: News out of Iraq certainly has the potential to drive commodity strength in oil and precious metals this week. UK gilts sill be watching the UK CPI for a further steer on potential rate hike by the BoE.