Risk sentiment weaker after military action in the Middle East. This with stronger US data drives up US Treasury yields

Risk sentiment weakened following reports of increased military action in the Middle East. The US-Iran conflict continues to drag on, with no imminent sign of a peace deal. US economic data showed further positive momentum in growth and inflation. Oil prices and global rates are higher, US and European equities are weaker, and the USD is broadly stronger. The NZD has underperformed further, unwinding last week’s rally.

During NZ trading hours, the US and Iran exchanged heavy fire in the Middle East. The conflict began with the US striking an empty oil tanker that was attempting to skirt the US Navy blockade, and Iran retaliated by firing missiles at US bases in Bahrain and Kuwait, along with drone attacks on vessels in the Strait of Hormuz. Overnight, there were no fresh developments, but it is fair to say conditions remain tense, the so-called ceasefire is on shaky ground, and there is still no sign of the imminent peace deal that Trump has repeatedly claimed is forthcoming.

Bloomberg reported a change in tactics, with the US quietly coordinating with ships crossing the Strait, advising them to switch off their transponders and stay close to the Omani coast. This is incrementally positive for global oil and gas supply, but negative headlines around military action have remained the dominant force driving oil prices, with Brent crude rising to USD98 per barrel.

Higher oil prices have been the key driver of higher global rates, while stronger US economic data have supported the rise in US Treasury yields. US economic data for May showed continued positive growth momentum and increased inflationary pressure. The US ISM services index came in higher than expected, rising to 54.5 with broadly based gains across industries, while the prices paid index rose to a four-year high of 71.3. ADP private payrolls increased by 122k, the strongest gain in 16 months.

The market has now moved to price in an even chance of a 25bps Fed hike by the October meeting. Treasury yields are up 4-5bps across the curve for the day. The 10-year rate is at 4.49%, up 3bps from the NZ close.

In equity markets, the US S&P 500 is currently down 0.5% and, if that is sustained into the close, it would snap a nine-day winning streak. The Euro Stoxx 600 index closed down 0.7%.

In currency markets, the USD is broadly stronger, with the dollar index showing a modest 0.3% gain for the day. The NZD has notably underperformed, down 1% from this time yesterday to 0.5865. That takes the loss this week to 2%. However, in the context of the strong rally following the RBNZ’s hawkish hold last week, it suggests that some positioning adjustment has driven the move more than a fundamental reassessment of the NZD’s path. The RBNZ will need to deliver rate hikes to provide more fundamental support, and a reduction in the risk hanging over the Middle East conflict will also be required.

The AUD is weaker at 0.7130, while NZD underperformance has pushed NZD/AUD down to 0.8220. Australian GDP data did not move the needle. GDP rose a modest 0.3% q/q in Q1, consistent with fading growth momentum ahead of the US-Iran conflict.

Given its underperformance, all key NZD crosses are weaker. The JPY has outperformed other majors, but broad USD strength has still pushed USD/JPY above 160. BoJ Governor Ueda’s anticipated speech did not explicitly indicate that he would vote for a mid-June rate hike, but nor did he appear to rule it out. There were plenty of “ifs and buts”, but he also said that “based on the data and anecdotal information available so far, the upside risks to prices appear to be greater overall and are likely to emerge sooner”. Pricing for a BoJ June hike edged up to 23bps.

Japan’s cabinet approved a 3.1 trillion yen (USD19.4b) supplementary budget to cushion households from inflation. While this had been previously flagged, the extra stimulus comes early in the new fiscal year, keeping JGB investors on edge and doing nothing to allay fears of overly easy fiscal policy leading to higher debt. The combination of easy monetary and fiscal policy helped drive Japanese equities to a fresh record high, while maintaining downward pressure on the yen.

In the domestic rates market, there was further unwinding of the post-RBNZ move in rates, with better receiving at the short end of the swaps curve. The 2-year rate fell 3bps to 3.49%, while the 5-year and 10-year rates were unchanged. NZGBs saw a similar move, with the 2-year rate down 2bps and no change in 10-year and longer rates. The OIS market still shows July almost fully priced for a 25bps hike, while three full rate hikes are priced in for the year.

NZ’s terms of trade fell 2.0% q/q in Q1 from a record high. The data implied stronger export volumes than we had assumed, supporting Q1 growth estimates, although we will not finalise that view until further quarterly activity indicators are released over the next week. Residential building consents continue to skyrocket, with the near-11% surge in April taking them 53% higher than a year ago. The figures bode well for building activity over coming quarters, although the non-residential sector remains a modest drag.

In the day ahead, NZ building work put-in-place data will be released, feeding into Q1 GDP estimates. In central bank speak, RBA Governor Bullock will appear before lawmakers later today, and ECB President Lagarde will speak tonight ahead of a widely expected rate hike next week.

Jason Wong is the senior Markets Strategist at BNZ Markets.