The Iran war has triggered a puzzling market trend

The minute we all wondered virtually has add up. Oil color has surged yesteryear $100 per barrel and markets are coming under serious strain. When I wrote an initial reaction to the Iran war last week, markets were still clearly pricing a “nothing to see here” scenario.

With the system of global governance in shambles and institutional checks conspicuously lacking, I wrote that markets may now be the only force left capable of imposing constraint. Think of markets as a congress that has to approve a continuation of war – except this congress can’t be bought off so easily.

US officials, of course, are still downplaying the carnage (in markets, that is – the carnage in Iran is a source of pride). President Donald Trump called the oil spike a small price to pay for security, while the US Energy Secretary Chris Wright said the recent surge in oil prices reflects a temporary “fear premium” and predicted prices would come back down in a matter of weeks.

Maybe they’re right, but the whole thing is starting to have a Ceausescu’s final speech on Palace Square feel. Sometimes history moves very quickly and the language of ‘temporary fear premiums’ ends up looking awfully silly.

Brent oil prices reached as high as $119 per barrel on Sunday night before coming back down a bit after it was reported that G7 finance ministers would discuss releasing petroleum reserves. Reports suggested there could be a 300 million barrel release. This would be a large release by historical standards but hardly sufficient to offset sustained shortages. Also keep in mind that the world consumes about 100 million barrels every day.

Crude oil prices are now up by about 50% since the US and Israel launched their strikes. JP Morgan was roundly mocked for its prediction that oil would hit $130 a barrel, but if things keep moving as they have been this will end up looking overly conservative.

Meanwhile, many people have been puzzled that all of this turmoil has not sent gold prices surging.  In fact, gold was down just over 1% as of around 10:00 GMT on Monday. This is being attributed to the prediction that the wave of inflation caused by surging energy prices will force central banks (namely the Fed) to hold off on interest-rate cuts, thus boosting the dollar and dampening interest in non-yielding gold.

I know we are in the habit of viewing central bank rate policy as having the gravitational pull of a large star, but does anybody really believe that, in the midst of a full-blown crisis and with tremendous uncertainty about what lies ahead, that bets on future interest-rate cuts are really driving price movements? The move in gold actually smells an awful lot liked forced liquidation behavior.  When the margin calls start coming (and they certainly are), traders sell what they can, not what they would prefer. Gold is one of the most liquid assets out there, which means it often gets unloaded when losses elsewhere need to be covered.

Meanwhile, here’s an interesting take. The Chicago Mercantile Exchange (CME), the world’s largest derivatives marketplace, has reportedly raised margin requirements on oil and oil products while lowering them for gold and silver. When you trade futures, you don’t actually pay the full value of the contract. Instead, you post margin, which is only a fraction of the contract value. Let’s say you’re buying oil futures worth $100k; you may be required to post $10k in margin, for example. This lets you control $100k of oil with $10k. When margin requirements are tightened, traders must put up more cash to hold the same position. Speculators often reduce positions as a result. This can have the result of cooling volatility or speculation.

Raising margin requirements on oil increases the cost of speculating on oil futures. Accordingly, lowering them on gold and silver allows traders to take larger positions in those assets with the same capital.

Now to be clear, margin increases are generally an automatic risk response and not an attempt to steer markets toward a particular macro result. These are generally fairly mechanical exchange decisions tied to risk management models and volatility.

But some analysts see a fascinating deeper mechanism at work, which, even if somewhat overstated, illuminates an important concept. Luke Gromen, for example, said: “This looks like they are trying to let gold be a release valve of the coming oil inflation. If so, this would be smart IMO, because if gold goes to $7,000, nothing happens…but if oil goes to $130, all hell breaks loose globally.”

The point Gromen is making is that if oil speculation explodes, prices can spike rapidly and cause real economic damage: gasoline prices surge, shipping costs spike, food prices rise, inflation accelerates. But what happens if gold rises to, say, $7,000 an ounce? There’s really not much immediate real-world impact. Sure, jewelry becomes expensive, gold investors get richer, and central banks holding a lot of gold benefit. But daily life doesn’t change much.

There’s not likely some kind of conspiracy whereby the folks running the CME get a tap on the shoulder about tinkering with margin requirements. Think of it more as a matter of alignment of incentives. Exchanges such as the CME are not neutral in the sense of being indifferent to market stability. They are part of the system and depend on that system.

When markets are under geopolitical stress, capital needs somewhere to go. If there are going to be fear-driven capital moves, better for that capital to plunge into gold than into oil because the macro consequences are much less severe. In this sense, gold can function as a pressure valve for geopolitical fear.

How the combination of risk management models, volatility indicators, and a human understanding of dangerous real-world instability coalesces at the CME is beyond my pay scale, but it would make sense for institutional mechanisms to lean toward system stability as a gnat moves unconsciously toward light.

Right now, gold is being sold to absorb the oil shock – a state of affairs necessitated by the severity of the market moves in recent days. From the point of view of keeping the whole system going, however, gold should be absorbing the oil shock via a different mechanism: money should be ploughing into gold as an escape valve with the idea that markets can absorb higher gold prices much more easily than a disorderly oil shock.

The problem, of course, is that we might get the disorderly oil shock anyway. No amount of tinkering with margin requirements can address physical shortages.

Ultimately, the global economy simply cannot withstand a sustained period of high energy prices without plunging into a recession – or worse. And the money that will be printed to deal with that recession (what else would they do besides print money?) will be where the real inflation bomb is smuggled in. 

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