More on Israel/Iran + Fed Thoughts

Into the start of the week: A cautious start in the Asia-Pacific region so far, with markets still a bit reluctant to price in more extreme scenarios for the current situation in the Middle East.

Energy commodities are trading firmer. Prompt WTI/​Brent futures are both up over 1.6% from Friday’s close at the time we’re writing this.

Elsewhere, the spot price for Gold is also higher and probing above the levels we saw in early May.

1.) An update on geopolitics

a.) Iran/​Israel update: On Friday, we wrote on the market implications of the Israel/​Iran war.

Over the weekend:

• Iran responds with a massive wave of retaliatory strikes.
• Israel is said to have asked the US to join the war against Iran.
• President Trump calls for both sides to ​“make a deal” and suggests that it could be possible that the US ends up involved.
• Missile strikes between the two sides continue – with Iranian energy infrastructure also targeted.

South Pars is one of the world’s largest gas fields, and the strikes over the weekend have led Iran to partially shut down operations there. Qatar also owns the field as well, and for now, there’s been no word on whether the country is shutting down its operations.

Again, for markets, there are two considerations to monitor. First, whether this conflict escalates to threaten energy infrastructure in the region – which we’ve seen happen to a degree already. Second, what this will mean for global input prices given the region’s central role in energy production.

At the time of writing, prompt crude and natural gas contracts are extending higher.

b.) The G7 leaders summit is underway in Alberta.

Ahead of last Friday, the agenda would have been easy to predict (tariffs, taxes and AI). But we suspect that there will be a lot more time spent on the current situation in the Middle East.

Unlike prior summits, there won’t be a joint communique.

2.) US news and notes

A few things to keep in mind for this week:

• The FOMC is up this Wednesday.
• Thursday is a market holiday in the US (Juneteenth).

For the FOMC – if it weren’t for the trade war, we would probably be talking up a rate cut for this meeting. After all, there are signs that inflation is decelerating (despite tariffs) while subtle cracks are beginning to emerge in the employment picture. Nevertheless, expect Chair Powell to continue to point to a myriad of risks that could still keep price pressures too elevated for the Fed’s liking.

In my old job as a sell-side strategist, I would have spent too much time over-analyzing what is important to watch for this Wednesday. Instead, I’ll just say this – the quarterly SEP is due to be updated this week (i.e – the ​‘dot plot’ projections) and the most important item to watch for is where end-2025 median dot is. This will give us a sense for how much the Fed expects to ease this year.

As of the March SEP, the median end-2025 dot was at 3.875% (implying two cuts for this year). Our own expectation is that the median won’t shift in the updated projections for this week. For what its worth, that is also in-line with current market pricing.

3.) The ​‘micro risks’ you should be watching – Part I

Last week, we were troubled to hear one prominent US senator suggest that it might be a good idea for the Federal Reserve to eliminate the interest it pays on reserves to commercial banks.

But doing so would be a catastrophic mistake. Let us explain as simply as we can without getting into the boring and dry specifics (those of you who are interested in that – feel free to reach out to us):

Remember that when a central bank like the Fed sets an interest rate target (or a range), it needs to ensure that the plumbing of the system is aligned. That means that the effective Fed funds rate – which is determined by the Fed funds market (where banks and government sponsored enterprises lend and borrow to each other on an unsecured basis overnight) – must fall within the target rate or range that the Fed sets. Failure to make this happen would mean monetary policy transmission risks. Right now, the Fed funds target range is 4.25-4.50% and the Fed funds effective rate is 4.33%. Some might quibble that this is a bit below the midpoint of the Fed’s range, but right now that is a minor inconvenience.

However, one of the three ​“administered” rates that the Fed uses to ensure that the effective rate is within the target range is the IOR (or interest on reserve balances). This is the rate at which banks earn interest on reserve balances that they hold at the Fed. Reserve balances are a liability for the Fed, and an asset for commercial banks.

Senator Cruz is suggesting that the US could save ​“a trillion dollars” by having the Fed eliminate this payment to banks. But he’s wrong for a few reasons:

• The Fed’s negative net interest income (when IOR payments > interest earned on UST/MBS holdings) does not impact the budget deficit. Instead, it’s recorded as a deferred asset and Fed remittances to the Treasury are paused until it’s paid off.
• By slashing the IOR to zero, the Fed would be inducing banks to switch from holding reserves to UST bills as assets. Implicitly, that would mean that the Fed would have to actively sell its holdings of UST back to the market.

In theory, that latter point would be VERY bearish for markets – because it would mean higher rates in the front-end.

So, no – this isn’t a good idea at all.

Later this week – we’ll talk about another micro risk to eye: the end of US dollar swap lines.

4.) The week ahead

This is a fairly busy macro week – especially given the plethora of central bank decision that we have incoming. We’ve covered the Fed a bit in point 2) above, and we’ll give a super quick preview for some of the major ones below.

• Bank of Japan (Monday night – Tuesday morning): Should keep the policy rate on hold at this meeting. Consumer prices remain too high for comfort currently, and the recent spike in energy prices won’t help things, but there are far greater risks to tightening too fast in a place like Japan (growth remains anemic, government debt costs have risen substanitally).
• Riksbank (Wednesday): This will be the Swedish central bank’s first cut since January. The SEK is the top performing currency this year against the USD – which also means that Sweden’s CPI is well below target. They need to cut further from here.
• Bank of England (Thursday): April CPI was higher than expected, but the latest employment/​earnings reading was softer than we’d expected. We’ll learn some more about the inflation backdrop this week with May CPI out on Wednesday, but the BoE will probably still elect to keep rates on hold this week.
• Swiss National Bank (Thursday): The May CPI reading was negative for the first time since early 2021. That makes this week’s decision an easy one to call – the SNB will cut rates by 25bps on Thursday.
• Norges Bank (Thursday): May CPI showed that prices were still a bit too high for the Norwegian central bank. This will almost certainly be a hold.

Data/​events for the week

Mon June 16

• Canada: Housing starts (May)
• US: Empire manufacturing (Jun)

Tues June 17

• US: Retail sales (May), Business inventories (Apr), Industrial production (May) + Senate resumes debate on tax bill
• Canada: International securities transactions (Apr)
• Germany: ZEW survey (Jun)
• Japan: Bank of Japan decision, Trade balance (May)

Wed June 18

• US: Federal Reserve decision, Housing starts + Building permits (May), Initial jobless claims, Net TICS flows (Apr)
• Canada: BoC’s Macklem speaks
• UK: CPI (May)
• Eurozone: CPI (May – final)
• Sweden: Riksbank decision
• Indonesia: Bank Indonesia decision
• South Africa: CPI (May)

Thurs June 19

• US: Juneteenth holiday
• Canada: CFIB Business barometer (Jun)
• UK: BoE decision
• Norway: Norges Bank decision
• Switzerland: SNB decision
• Turkey: CBRT decision
• Japan: CPI (May)

Fri June 20

• Canada: Retail sales (Apr)
• China: Loan prime rare
• Eurozone: Consumer confidence (Jun)
• UK: Retail sales (May)

5.) Portfolio strategy

At the moment, developments in the Middle East and what they mean for broader markets are what we’re watching. Tariffs, and the US tax bill, are still lurking in the background as secondary themes. 

As mentioned in our note on Friday…

• We are underweight US and Canadian fixed income in our balanced portfolio. The developments over the weekend and the potential for escalation do not portend to a shift in this view at this stage.
• We remain overweight alternatives – including Gold. Increased geopolitical uncertainty should continue to support the already existing fundamental reasons to remain long.
• We continue to prioritize defensive sectors and low volatility strategies in the equity sleeve of our portfolio.
• We see scope for the US dollar to rally in the near-term. That’s primarily as a substantial short position has been built already. Indeed, the risks of further escalation point to a possible squeeze in the FX market.

If the conflict extends for a substantial period of time, we would be wary of increasing exposure to markets that depend heavily on energy imports (India, China, Germany and Japan).