Forex: What is Actually Happening in the Strait of Hormuz?

Markets rallied on Wednesday after both the US and Iran said they’d agreed to a ceasefire to negotiate terms to end the war in Iran. Risk trades unwound quickly, pushing stock markets higher, the dollar lower and supporting gold. Crude prices had one of the largest daily drops in years.

But on Thursday, it appears the situation is reversing, with risk assets declining and investors returning to safe havens. It might be that investors overreacted to the news on Wednesday and are coming back to reality. As anticipated in our article on Tuesday, markets haven’t immediately priced in an end to the conflict. More than the war, what is affecting markets is the state of the Strait of Hormuz, and the ceasefire has not reduced the uncertainty in this era. In other words, for practical purposes, it’s as if both sides have punted the issue for two weeks, leaving the status quo in place. Therefore, it’s not actually a surprise that Brent has traded just under the $100 per barrel, in line with expectations from last Tuesday.

What’s Really Going On?

The initial market reaction was driven by an understanding that the Strait of Hormuz would be (mostly) reopened. That was explicitly said by US President Donald Trump and by Iranian representatives, who added a few caveats. However, in the subsequent hours, the situation around the Strait became increasingly murky. Iranian missiles continued to be launched against Gulf infrastructure, and there were reports of military strikes inside Iran.

Iran included as part of the conditions to reopening the Strait that Israel cease attacks on Hezbollah in Lebanon, which Israel rejected. By Thursday morning, Iranian media was asserting again that the Strait was closed. However, a certain number of ships were being allowed to pass under uncertain circumstances. Notably, however, no crude tankers have left the Gulf since the (apparently very fragile) ceasefire was announced. So, as far as the markets are concerned, realistically, nothing has changed since Monday.

Markets Re-pricing Risk and Monetary Policy Outlook

As of early Thursday, futures still indicate the ECB will hike rates twice this year. The BOE is still expected to hike once. The odds that the Fed will hold until the end of the year are at 74%, practically unchanged from the 76% a week ago. In other words, markets are simply responding to the “TACO” trade, as the immediate threat of a large scale escallation in Iran has been removed, but the major economic roadblock remains in place. Even gold has returned to trade around where it was before Trump issued his threat to attack on Iranian energy infrastructure.

The fact of the matter is that we really don’t know what’s going on. The focus now turns to negotiations between the two sides to be held in Pakistan on Friday. But neither has officially published its list of demands to reach a deal. The US 15-point plan has been widely discussed in the media and aligns with prior demands. There have been at least three versions purported to be Iran’s 10-point demands, and they differ notably. Iranian media have also published a 12-point plan, which includes additional elements that are clear non-starters for negotiation, such as Iran continuing to enrich uranium.

All this means that markets are reacting to rumours and likely to remain volatile going into the weekend. While assets could move on relative progress toward ending the conflict, the trends in Forex won’t assert themselves until there is clarity on whether oil can exit through the Strait of Hormuz.