The ongoing conflict between Israel and Hamas is causing financial markets to assess how it may influence the Federal Reserve’s future policy decisions.
Currently, fed funds futures traders believe there is a higher likelihood of no further action by the Federal Reserve this year. According to the CME FedWatch Tool, the probability of no action in November has increased to 85.8% from 72.9% just a day ago, and for December, it has risen to 74.2% from 57.6%. This would mean that the Fed’s main interest-rate target would remain at a 22-year high of between 5.25% and 5.5%.
However, it is essential to note a significant caveat. Traders, investors, and even the Fed have all made mistakes in the past, particularly when underestimating the strength and persistence of price pressures leading up to the current era of inflation. Therefore, it is equally plausible that the Israel-Hamas conflict could trigger a resurgence in inflation through higher oil prices. Macro strategist Henry Allen and research analyst Cassidy Ainsworth-Grace of Frankfurt-based Deutsche Bank are warning about the potential risk of a return to 1970s-style stagflation—a combination of inflation and slower economic growth.
Randal Stephenson, the head of investment banking at FE International, a mergers-and-acquisitions advisory firm headquartered in New York, stated that it is premature to determine whether the market’s knee-jerk reactions on Monday will be sustained or intensify. The outcome depends on the speed and extent to which this conflict escalates.
In addition to the higher chances of no action by the Fed this year indicated by fed funds futures trading on Monday, there was also an increased demand for 10- and 30-year Treasury futures. This greater demand suggests that corresponding yields could decline when the cash market reopens on Tuesday. It is worth noting that the Treasury market was closed on Monday for Columbus Day and Indigenous Peoples Day.
Gold Surges on Safe-Haven Appeal, Oil Prices Climb
Gold has experienced a significant surge in value due to its safe-haven appeal, while oil prices have climbed by over 4%. In the U.S., stock market indices including DJIA, SPX, and COMP have reversed their downward trend and turned positive. This change of direction comes as investors shift their attention to remarks made by Dallas Fed President Lorie Logan, suggesting that there may be less urgency to raise the fed funds rate. Meanwhile, Fed Vice Chair Philip Jefferson acknowledges the impact of higher Treasury yields and promises to consider financial-market developments in future policy decisions.
Challenges for Central Banks
FE International’s Stephenson notes that despite the Federal Reserve’s efforts to curb inflation and achieve a smoother economic landing, unexpected shocks like the recent events in the Middle East pose a significant risk. While Stephenson believes that this conflict between Israel and Hamas may not have a long-term impact if contained, there is concern that its spreading to other regions could lead to a rise in oil prices, resulting in inflationary pressures that would complicate the Fed’s goals.
The Fed’s Projections and Market Impact
The Federal Reserve’s most recent projections from September 20 indicate an expectation of one more rate hike by the end of this year, aiming to bring inflation closer to the 2% target through 2026 and beyond. However, Brent Schutte, Chief Investment Officer of Northwestern Mutual Wealth Management Co., emphasizes that tragic events such as the situation in Israel have real human impacts that cannot be overlooked. He also warns that the ongoing events have already influenced markets and could potentially act as a growing headwind if they escalate. Schutte and his team will closely monitor the situation and its potential impact on markets.