Has The Fear Trade Returned?

The simultaneous sell-off in stocks, rise in the U.S. dollar, gold and oil prices tell us that investors are nervous about the situation in Syria. The possibility of a military strike on the country is growing by the minute and investors are worried that it could destabilize the region. Widespread conflict in the Middle East has already wrecked havoc on the region but this time the world's oil supply could be impacted. Syria borders Iraq and is an ally with Iran, two countries that constitute nearly one-fifth of OPEC production. At the same, the risk of war always make investors nervous and it is coming at time when there are already concerns about the debt ceiling and the drag that Fed tapering could have on the U.S. economy.

Up until this month, investors around the world were quietly putting on risk trades after better than expected economic data sparked confidence in a stronger second half recovery. While resilience of the EUR/USD Tuesday suggests that the hope is still alive, the fear trade could be coming back from dead. The simultaneous rise in the dollar and gold is a clear sign that there is a flight to quality while the rise in the Yen signals liquidation of carry trades.

We don't know how quickly the Obama Administration will decide to act on Syria but the level of unease in the markets will probably worsen before it improves, leading to a deeper sell-off in equities, strength in safe haven assets and weakness in emerging market currencies.

Syria has already threatened to retaliate and defend itself in ways that could "surprise" the world according to the country's Foreign Minister. While Syria is not a major exporter of oil, prices hit 1.5 year highs on the fear that attacks on Syria could affect major suppliers in the region. Gold prices also rose to its highest level in three months as investors sought other assets for safety. If there is an international military strike on Syria, we could see more panic selling but if there are signs a swift victory, order will be restored, paving the way for a relief rally. The price action in the financial markets was a classic example of how geopolitical risks can overshadow economics and how thin trading conditions could exacerbate movements in the financial markets. U.S. pending home sales are due out Wednesday but the focus will remain on Syria.

Behind The Slide In USD/JPY
For many Japanese Yen pairs including USD/JPY, Tuesday's sell-off was the largest one-day decline in nearly three weeks. The more than 1% sell-off in USD/JPY and nearly 2% drop in AUD/JPY and NZD/JPY was caused by a confluence of factors. Markets around the world sold off on concerns about an international military response to Syria but that was not the only reason for the poor performance in the Yen pairs. The Yen crosses were also hit by a meltdown in emerging market currencies, uncertainty about the consumption tax in Japan and the backup in U.S. Treasury yields. At the end of the day, all of these factors led global investors to unwind their short Yen positions. Selling the Yen against the dollar and other major currencies was some of the most popular trades this year and even though there's still trillions of dollars in the short Yen trade, if none of the recent uncertainties are resolved in a positive way, more investors could opt to unwind their long USD/JPY positions in the near term. In the long run however, fundamentals still support a rally in USD/JPY but at this stage, buying on strength is probably smarter than buying on weakness unless the pair drops down to exceptional value points. Economic data in Japan continues to improve with the country's small business confidence index ticking slightly higher. No data was scheduled for release Tuesday night but Bank of Japan Deputy Governor Iwata was slated to speak at the Kyoto Chamber of Commerce Tuesday evening.

EUR: The Good News Keeps Rolling In
While all of the major currencies endured steep declines against the U.S. dollar, the euro recovered earlier losses to end higher against the greenback. The 1.34 level is like a magnet for the currency but euro-zone data has been good, which provides underlying basis for the strength in the euro. According to the IFO Institute, German businesses grew more optimistic about current and future conditions in the month of August. The IFO index rose to 107.5 from 10.6.2 with improvements seen in both sub-indices. This report is consistent with other releases in the euro zone showing that the recovery is gaining momentum. However the 1.34 level in the EUR/USD is still being tested and without stabilization in sentiment, it may be difficult for this level to be breached in a meaningful way even if the rest of this week's euro zone economic reports are good. All of the major stock market indexes in the euro zone closed down more than 2% Tuesday while bond yield spreads in the region widened. The euro zone is not of the woods yet but compared to other parts of the world, its outlook is brighter which could help the euro outperform other currencies beyond the U.S. dollar. No euro zone economic reports are scheduled for release Wednesday but German unemployment and retail sales numbers are expected later this week.

CAD: Impact Of Syria Tensions On Oil
Of all the major currencies, the one that held up best in the face of widespread selling was the Canadian dollar. The loonie ended the North American trading session unchanged against the greenback thanks in large part to the rise in oil prices. The move that we have seen in oil could be just a taste of how much crude could rise if Syria is attacked. The Canadian dollar's correlation with oil prices has been shaky this year but on a day when fear is driving price, the rise in oil was enough to lend support to the loonie. At the same time, 1.06 in USD/CAD will be a tough level to break and the move in oil gives the currency pair even stronger reason to fail at this rate. The Australian and New Zealand dollars on the other hand experienced steep losses that would have probably been worse if not for the rise in gold prices. No economic data was released from any of the commodity-producing countries Tuesday but data from China was slightly better than expected. While industrial profits held steady last month, China's leading index ticked higher. Australian housing market data and Canadian average weekly earnings are on the calendar Wednesday but these second-tier reports are not expected to have any impact on commodity currencies.

GBP Moves Lower Ahead Of BoE's Carney Speech
The selloff in the GBP/USD can be attributed to risk aversion but the rally in EUR/GBP actually reflects the diverging the outlook for the euro versus sterling. This morning's better than expected German IFO report confirmed that the euro-zone recovery is gaining traction and while U.K. data has also been good, the lack of market-moving data this week and the prospect of dovish comments from Bank of England Governor Carney on Wednesday have weighed on the British pound. Carney is scheduled to deliver his first major speech, Wednesday, on monetary policy. The new governor wasted no time in overhauling processes at the U.K. central bank and he will most likely be asked a multitude of questions about his commitment to keep interest rates low under his new forward guidance policy. We know that the BoE has no intention of raising interest rates until 2016 but recent improvements in U.K. data has led investors to price in a move as early as the first quarter of 2015. The central bank is skeptical about whether the recovery can sustain its current momentum, a view that many see as overly pessimistic particularly after upward revisions to GDP growth. As we expect the central bank governor to remain dovish, we also feel that the recent pullback in the GBP/USD could be the beginning of a steeper slide that could also take the currency pair down to 1.54.

Kathy Lien, Managing Director of FX Strategy for BK Asset Management.