Market reaction was right out of the Mideast uncertainty playbook – oil, gold, and yen rally, stocks sell-off.
The question now is will the rally be temporary or will safe haven assets remain elevated. Traders remember well the whipsaw in mid-September when the oil rally faded – almost overnight- and then over the following 2 weeks after the attacks on Saudi production facilities.
The killing of Soleimani is more difficult to handicap. In the case of the September attacks on the Saudi oil facilities, the dynamics of supply were quickly recognized. The production facilities incurred less damage and were back on line faster than originally feared. In this case however, the supply implications are far less clear. Iran’s reaction and potential retaliation are likely to be carefully calculated and could play out over a much longer timeframe.
This should keep the geopolitical risk premium in oil markets elevated in the coming weeks. This risk may be exacerbated because the Trump administration – which until this attack has been hesitant to respond – has now raised the stakes. The risk of direct confrontation between the US and Iran may be small, but it’s growing. At a minimum, Iranian retaliation risks setting off tit-for-tat skirmishes across the region. As always, the real wildcard in Mideast events is who might potentially be dragged in.
All of this is happening in an environment where supply and demand in global oil markets appeared to be finding an equilibrium. Price volatility collapsed after the September Saudi attack and had remained fairly low through November and December.
The risk-off bid in bond yields however seems overdone. Until we see what, if any, reaction Iran has, there is little reason to believe this will dent the real economy. At the margin, elevated oil prices, if prolonged, could eventually trickle through to headline inflation.
In the stock market, the killing of Soleimani seems like a convenient excuse to take some profits in an asset class that has had a great run, but few love at recent valuations.