Markets in the Fog of War

All the focus is on oil prices, but the real story now is the Dollar

In the space of one week, we’ve gone from markets thinking oil prices would barely move to people falling over themselves predicting oil above $100 per barrel. I’ve been on the alarmist end of the spectrum as far as oil prices go, on the simple intuition that Iran’s regime is fighting for its survival. Since it can’t hope to match the US and Israel militarily, its only play is to spike oil prices as much as possible, in the hope that this turns public opinion in the US against the war. Iran’s de facto blockade of the Straits of Hormuz is a powerful weapon in this regard.

The Brent oil price is now up 28 percent from before hostilities began. On a similar timeline after Russia’s invasion of Ukraine, Brent was up 17 percent. If markets were massively complacent at the start of this past week, that’s definitely no longer true and a decent risk premium has been priced. In my opinion, the interesting story is thus no longer oil, but the Dollar which - as this past week progressed - has traded remarkably soft, even as oil prices ratcheted up. In today’s post, I’ll cut through the “fog of war” to what I think are the really interesting market phenomena beyond oil.

• We’re going back to Dollar weakness: something really remarkable happened on Friday. Markets were descending into all-out panic over Iran and the Brent oil price ended the day almost nine percent higher. This kind of price action should have seen the Dollar rise as it normally does when risk aversion spikes, but that didn’t happen. Instead, as the scatter plot below shows, the Dollar fell almost exactly in line with past moves when payrolls surprised on the downside. In my opinion, this signals that the “shock” phase of this conflict is over and markets are going back to normal. As I noted in Thursday’s post, recent Dollar strength has just been about short-term repatriation flows by US investors. These flows never last long and - barring a truly catastrophic spike in oil prices - it looks like they’re already done. This means we’re going back to Dollar weakness.

• Markets are transitioning to trading winners and losers: about two weeks after Russia’s invasion of Ukraine, markets transitioned from broad-based, risk-off price action to differentiating between winners and losers from higher oil prices. A necessary condition for this shift was a recovery in global risk appetite, which - as I argue above - has just begun. Indeed, Friday was the first day markets started pushing up currencies of commodity exporters, while energy importers got hit. The chart below shows how prices moved on Friday across different assets. The red bars show the Brent oil price (CO1), gold (XAU), silver (XAG) and the S&P 500 (SPX). The blue bars show the rise (+) in currencies versus the Dollar. In emerging markets (EM), South Africa (ZAR), Brazil (BRL) and Chile (CLP) rose, while oil importers like Thailand (THB) and the Philippines (PHP) got hit. This price action is in line with my markets preview right after hostilities began.

• Russia is the single biggest winner in all this: as my readers will know, I spend a lot of time - together with Ben Harris at Brookings - tracking Russia and its oil exports. In fact, together with Harold Koh from Yale Law School, we recently put out a proposal on how Europe can crack down on the shadow fleet with the goal of pushing down the Urals oil price and depriving Putin’s war machine of cash. Unfortunately, what’s unfolding now is the exact opposite. The closure of the Straits of Hormuz means global oil markets are hurtling from surplus to deficit. Overnight, Russian oil has gone from being a pariah - trading at a steep discount - to being highly sought after, aided by the US lifting some of its sanctions. The chart below shows my best guess for what’s going on. The discount on Urals is likely to have shrunk below $10 per barrel, which is a massive windfall for Putin. Indeed, there’s anecdotal evidence the Urals price has topped Brent in India, a sign of just how massive the hit to oil markets is. It’s already clear who’s the real winner in this war and that’s Russia.

This is my attempt to cut through the “fog of war.” The reality is that Brent now prices a big risk premium. Amid all the chatter about oil going above $100, better therefore to focus on where people aren’t yet looking. That’s the Dollar, EM differentiation and - to my great chagrin - Russia.