Well, there’s been no shortage of headlines to keep markets busy over the past week as the conflict in the Middle East has escalated (to put it politely). Yet despite the sheer scale of strikes and retaliation across over a dozen countries, markets have remained relatively calm.

Of course, there have been some moves in markets. But we’ve not seen the frenzied or violent reaction that other conflicts have induced.

The VIX, a measure of panic and volatility in markets, is still sitting at only half of what it was in the aftermath of Liberation Day last year. US Treasuries have sold off on fears of higher inflation, but not by much. The USD has strengthened a bit, with the DXY up ~1% over the last week. Traders have slipped back into treating the USD as the safe haven it has always been (recent anti-trump trades aside).

Bigger reactions, to no surprise, have been concentrated in oil markets. And even then, the move in Brent Crude above $90USD a barrel came slower than expected. (See our COTW for more).

After one volatile shock after another, it’s not surprising to see markets less reactive. However, with the conflict now spreading across several countries and no signs of de‑escalation, we don’t think this muted market backdrop will last.

Unfortunately, things are likely to get worse before they get better. We’re bracing for much higher volatility, with a bigger market reaction in the near term. Our hope that markets rebound quickly once the dust settles, as they did in 2022 following the Russia and Ukraine crisis period.

Contemplating the global fallout, the risks ahead are pronounced. With disruptions to oil, gas, and shipping, a lift in near term global and kiwi inflation is all but a done deal. But the downside risks to global and domestic growth cannot be ignored either. And ultimately, under this kind of supply shock induced inflation, it’s the damage to demand that is likely to dominate.

For households, higher petrol prices at the pump will just add to the cost-of-living crisis we keep hoping (and thinking) will end. We know increases in essentials, like petrol, act like a tax on household consumption. They squeeze disposable incomes and pull spending away from everywhere else. It’s something the Kiwi consumers and the broader economy has already been grappling with amid the surge in prices across household utilities. But now add to that higher prices at the pump, and Kiwi household budgets are about to become even more constrained, with areas of discretionary spending set to bear the brunt further.

Indeed, input costs are going to go up across the board for firms. But in an already fragile demand environment, not all businesses will be able to pass on the costs to consumers. It will be uneven. Sectors like retail and construction, which are amongst the weakest, will struggle to pass through higher costs.

Mixing together tighter margins, falling profitability, and a shell shock wave of uncertainty, businesses will be more likely to pull back on investment, hiring, and growth-oriented decisions… reinforcing a weaker growth environment.

So where does this all leave the path of interest rates then? Well for us the idea of rate hikes anytime soon looks more premature now than before the war. Yes, inflation will likely spike further in the near term. But central banks, the RBNZ included, will need to (and are supposed to) look through the near-term noise. Looking to the medium‑term instead, where monetary policy is targeted towards, the weakening growth outlook simply matters more. We suspect Central Banks, and the RBNZ in particular, may well have to tolerate higher inflation in the short run to avoid tightening into a slowing global economy.

Financial Markets

The comments below were provided by Kiwibank traders. Trader comments may not reflect the view of the research team.

In rates, Kiwi swaps move higher in parallel moves to global rates

“With the weekend developments in the Mid-east, NZ swap rates traded higher in a broadly parallel move, largely tracking similar moves in offshore markets. Two-year IRS moving from around 2.95% to 3.12%, with 10-year from 3.94% to 4.11%. Initial moves in the week were tied to headlines around the outbreak of conflict, tracking moves seen in offshore markets. Safe-haven Dollar buying was evident – countering much talk of late around the status of such, with the USD Index higher by around 1.4% week on week. Rates market reaction over the week could be viewed as relatively orderly with no serious gyrations, with markets seemingly looking through the immediate headlines to the inflationary and policy/short-rates aspects, and trending consistently higher. Domestic data was thin on the ground, with the perhaps the key prints being Australian Q4 GDP mid-week given the hawkish rhetoric from the RBA of late, and the US jobs report after our close on Friday. Australian GDP did print as expected, though it appeared that the market had talked and priced itself into a larger figure than the expected 0.8%. Immediate reaction on the day was a rally in bills and a dip in the currency – although these did unwind the following day.

Overall, short-end movements saw typically tighter policy priced. The US curve reducing priced easing, with Fed Funds futures pressured throughout the week with year-end contracts some 20-points lower over the week, while AU and NZ OIS curves increased priced tightening probabilities. The implied rate path for the OCR having shifted to now price a full 25-point move by the October review, and the half chance of another in December, with the Q3 and Q4 cash averages implied at 2.39% and 2.54% against the MPS projections of 2.28% and 2.38% respectively. Whether the recent market movements draw any RBNZ comment at any of the upcoming speaking engagements will be interesting. If anything, the domestic inflation front may be viewed as a little more murky of late, with recent business and consumer measures continuing to indicate elevated expectations that are also trending higher, combined with reports of further increases in local authority rates which may be counter to the MPS expectations for an easing in these administered prices, with oil now adding a new dimension to this.

As for the rates in general, while the international environment is seemingly more willing to look through the near-term headlines and concern itself with the inflationary aspects and pricing the appropriate policy responses, this measured approach may still see headlines related to the Mid-east situation upend this none the less. This leaves the front of the curve here perhaps the area where local factors may still exert some influence, particularly susceptible to any comments from the RBNZ indicating that the market is at risk of getting ahead of itself or that it remains comfortable with their most recent projections given the most recent pricing .” Graham Hughes, Trader – Financial Markets.

In currencies, the NZD is under pressure

“The NZD remained under pressure last week as safe haven demand lifted the USD, with the DXY pushing from 97.80 to a high of 99.68 before easing to 98.85 into the close. This drove NZD/USD down to 0.5850, which continues to act as key interim support. While the Kiwi staged a modest rebound, topside remains capped near 0.5950, and the pair ended the week around 0.5900. NZD/AUD also softened, touching 0.8350 before recovering toward 0.8400. Both antipodeans remain sensitive to risk sentiment, though the AUD continues to outperform the NZD during brief periods of stabilisation.

Over the weekend, geopolitical risks escalated, with expanded US/Israeli targeting and Iran indicating potential strikes on civilian areas—reducing hopes of near term de escalation. Early signs of supply chain strain have added to uncertainty, weighing further on risk sensitive currencies. At the same time, a weak US jobs report complicated the Fed’s outlook: signs of a softening labour market would typically reinforce rate cut prospects, but the risk of a geopolitically driven inflation shock leaves the Fed in a more difficult position. As a result, the NZD remains highly responsive to incoming headlines.

From here, we continue to watch interim support at 0.5850, with 0.5790 becoming of interest on a break lower. On the topside, 0.5950 should cap for now. However, any positive Middle East developments could see the NZD regain momentum quickly, supported by the backdrop of softer US labour data.” Hamish Wilkinson – Senior Dealer, Financial Markets.

Weekly Calendar

While most market attention will be on new headlines and developments from the Middle East, there are a couple of notable data points out this week.

• China has price data out later today with the release of February’s CPI and PPI in our afternoon. Consumer prices are expected to show a slight strengthening with headline inflation expected to lift 0.9% over the year up from a mere 0.2%. Much of the move however is expected to be helped by seasonal holiday demand from the Lunar New Year which is expected to have firmed up food prices. Meanwhile, on the producer side, prices are still expected to remain in deflation, but the pace of decline should ease, with consensus pointing to a 1.1% fall over the year.
• The US will also get an assortment of price data this week. The US CPI for February is set to be released on Thursday, while the PCE for January will be out over the weekend. Both measures of inflation are expected to show prices holding steady over the year, the CPI at 2.4% and the PCE at 2.9%. However, the CPI is of course more timely, so could expect to see markets dismiss the PCE if we got a soft read on CPI. For CPI, recreational goods and services are expected to be hot spots over the month. However moderations in rents and expected declines across autos are set to provide some offset.
• Here at home we’ve got a mix of GDP partial data alongside some more timelier PMI and net migration data. On GDP we’re shaping up for another firm quarter of growth. T.O.T last week was solid, lifting 3.7% over the quarter compared with expectations of a shallow decline. And don’t forget Retail sales over the quarter also performed well on data released a couple weeks ago. But last week’s building activity data suggests construction will be an offset, with weakness still evident across both resi and non‑resi. We’ll see how the partials for manufacturing come through this week and put out our finalised pick later on. On Kiwi net migration, the data for January should continue to confirm that we’re be past the low point on overall net migrant arrivals for this cycle. We’d expect to see annual net number in the 12-15k range. Not flash compared to our long term average of ~30k. But certainly better than the 8-10k we we’re seeing in the middle of last year.

See our "Weekly Calendar" for more.