Gold Signals Conflict Escalation Fears

Two counterintutive things happened this week that could be spelling out increased volatility across currency pairs next week. US yields rose to multi-month highs, but gold prices also rose. This breaks the usual pattern and raises the question of what kind of warning signal the market might be sending. To further add to the issue, gold pricesgold prices have rocketed higher this week, becoming the best-performing precious metal.

Normally, treasury yields move in opposition while gold and sliver move in tandem. The easy explanation is that gold is a safe haven asset, so it rose due to escalation of the conflict in the Middle East. However, in the past, gold has faced downward pressure while the US was at war with Iran, as the dollar gained strength amid safe haven flows. So, why is gold rising faster than the dollar now?

A Bigger Escallation Concern

Up until now, markets were generally concerned about the geopolitical situation, but with the focus being on the Strait of Hormuz. The constraint of crude flows would increase energy prices and have fairly predictable impacts on financial markets. Even if the situation escalated to a full scale war between the US and Iran (such as a US ground invasion), the main concern still remained with crude supplies.

The US is a net producer of crude, and the largest supplier to Europe. Since the closure of the Strait, it has stepped up exports to Asia as well. Higher crude prices generally support the US economy on balance, even if it creates some internal price distortions. Overall, that supports the dollar, and with the US far from the conflict itself, the dollar is a natural safe haven.

The Red Sea Is Different From the Strait of Hormuz

The Houthi attack on shipping in the Red Sea, and the US moving to engage the region militarily, changes the equation. Although shipping through the Red Sea has been disrupted occasionally during the war, a long-term suspension of shipping through the lane could have broader economic impacts.

Houthi attacks have closed the Red Sea in the past for extended periods, increasing shipping costs between Asia and Europe. The concern is that general cargo costs could increase, dragging on the world’s largest manufacturing economy (China) and the world’s second largest consumer economy. This could finally have a negative impact on the US as it would hurt demand from its largest trade partners.

The Dollar vs Gold

The escalation in the conflict coincided with a deterioration in optimism around the AI trade, which hurt US investor sentiment. In fact, US stocks are expected to close lower this week. The dollar still managed to rise through the week thanks to higher Treasury yields as investors priced in an increasing chance the Fed will hike rates to deal with inflation.

What that means for forex traders is that gold is rising faster than the dollar, and both are competing for safe haven status. The sharp increase in silver, another safe haven asset, suggests that investors are turning more defensive, and that could push gold prices higher once again. If the situation in the Middle East continues to intensify, the market could turn increasingly risk-off, but that could benefit both the greenback and gold.