The best hedge trades for geopolitical conflicts: crude oil, gold, or Japanese yen?

The changing situation in the Middle East is constantly disrupting the global financial markets. Yesterday, the media reported that Israel is determined to retaliate against Iran, causing a plunge in US stocks and Bitcoin, while gold prices rose. The price of gold approached the historical high set last week, rising by 1.76% to above $2385 per ounce at one point.

Overnight, the three major US stock indexes turned lower during trading, with the Nasdaq falling by 1.8%, the S&P declining by over 1% for two consecutive days, marking the largest two-day drop since the collapse of Silicon Valley banks, and the Dow falling for the sixth consecutive day.

On April 15th, a team led by Citigroup analyst Dirk Willer pointed out in a recent report that the conflict between Iran and Israel is unlikely to escalate in the short term, reducing the risk of a significant increase in oil prices. If oil prices do not surge, global markets may quickly return to a trading pattern centered around the US Federal Reserve.

However, if the conflict escalates unexpectedly, Citigroup believes that gold and the Japanese yen may be better hedging choices for investors:

The most effective hedging tools are usually those that are positioned in the "wrong" direction in the market. In the current environment, shorting the US dollar against the Japanese yen may be a better choice than going long on the Swiss franc.

Gold is often seen as a safe-haven asset and tends to perform well during periods of rising geopolitical uncertainty. Therefore, increasing exposure to gold can also serve as a hedging strategy for portfolios. If the conflict escalates and stimulates central bank gold purchases, the price of gold may rise to $3000 per ounce ahead of time.

Regarding the trend of oil prices, Citigroup believes that the current oil market has already absorbed some of the risk premium, raising the short-term oil price forecast from $80 to $88. If tensions significantly escalate, oil prices could rise to around $100, but this is not the base case assumption.

Goldman Sachs, on the other hand, believes that the current oil price includes a premium of about $5-10 per barrel. If oil transportation through the Strait of Hormuz is disrupted, oil prices could rise by 20% in the first month, and if the interruption continues for several months, oil prices could double.

Citigroup: Gold and Japanese Yen Will Be Good Risk Hedging Choices

Citigroup believes that although the situation is not clear and may change rapidly, key signals indicate that the likelihood of escalation is not high. The main channel through which Middle East conflicts transform into global macro events is often a significant rise in oil prices. However, the current low risk of a significant increase in oil prices means that global markets should refocus on the monetary policy of the Federal Reserve.

Citigroup states that if tensions escalate and the conflict further intensifies, Iranian oil production faces risks, leading to a surge in oil prices. This would mean that the Middle East conflict becomes more important for global macro assets, putting pressure on risk assets. In such a scenario, the market tends to seek assets that can hedge risks. From a fundamental perspective, among typical hedging tools, there is a preference for being long on the Japanese yen rather than the Swiss franc. Additionally, going long on gold is also an option:

Escalating geopolitical tensions may further support the price of gold through safe-haven demand and purchases by emerging market central banks. In a bullish scenario, we expect the price of gold to rise to $3000 per ounce by 2025, and a significant escalation of the conflict could accelerate this process Despite the significant increase in nominal and real interest rates, the pricing of federal funds rate futures has become more hawkish, but the price of gold has recently soared to record levels in the past few weeks. Geopolitical hedging, demand for alternative legal tender, and strong physical demand have pushed up the price of gold in recent months.

The tension in the Middle East may stimulate the trend of emerging market governments purchasing gold for long-term diversification of reserves.

The Japanese yen against the US dollar hit a new low for the fifth consecutive trading day since 1990, with a cumulative decline of over 8% so far this year, falling to around 154 yen, exceeding the level that some analysts warned could trigger direct intervention by Japan. Analysts say that one important reason for this situation is that recent strong economic data in the United States suggests a delay in rate cuts by the Federal Reserve.

Bank of Japan officials have warned earlier that they are prepared to take action to support the yen if necessary. Although the Bank of Japan abandoned its negative interest rate policy last month, the impact on supporting the yen is limited due to interest rates still being much lower than in the United States.

Some analysts point out that the "safe-haven property" of the yen is the result of the combined effects of loose monetary factors and capital market arbitrage trading. Japan's long-term low inflation relative to Western countries has led to a high sustainability of low interest rate monetary policy, making it a major reason for attracting foreign capital investment in its currency during economic crises.

However, many analysts point out that considering the limited room for the Bank of Japan to raise interest rates, the interest rate differential between the US and Japan may remain high for a longer period of time, and the potential upside of the yen exchange rate is limited, therefore challenging the yen's "safe-haven" status.

Citi: Oil prices may fall in the second half of this year

Citi believes that the current oil prices already incorporate expectations of continued tension, raising the oil price forecast from $80 per barrel to $88 per barrel. It is expected that by the third quarter of 2024, if the situation eases, oil prices will fall back to the $70-80 range. If the situation escalates significantly, oil prices could approach $100, but this is not the base case:

The tension in the Middle East will continue to support the rise in oil prices. The recent oil price forecast has been raised, with the Brent crude spot price forecast for 0-3 months raised from $80 per barrel to $88 per barrel, and the average price for the second quarter of 2024 raised from $78 per barrel to $86 per barrel.

The market has already priced in the continued tension in the Middle East at the level of $85-90 per barrel. If the situation eases in the third quarter, oil prices could quickly fall back to the $70-80 per barrel range.

If the situation continues to escalate, oil prices could rise above $100 per barrel. There may be an increased risk of Iran partially or temporarily closing the Strait of Hormuz, or Iran attacking oil facilities in the Gulf region, which could further push up oil prices.

Since the beginning of this year, with the escalating tensions in the Middle East, the two major global energy futures, WTI crude oil and Brent crude oil, have both risen significantly. Last week, the global benchmark Brent crude oil briefly broke through $92 per barrel, reaching its highest level since October last year.

Colin Cieszynski, the portfolio manager and chief market strategist at SIA Wealth Management, stated in a media interview that crude oil surged last Friday, and over the weekend, Iran's actions "have not really escalated the situation so far," leading to some short-term profit-taking in the market.

Goldman Sachs believes that while it is difficult to accurately assess the geopolitical risk premium (the compensation investors demand for the risk of reduced oil supply due to geopolitical shocks), based on pricing frameworks and hedging costs, a rough estimate suggests that the current price includes a premium of about $5-10 per barrel. This implies that the market believes there is a 15% probability of a 4 million barrels per day supply reduction in the next 12 months or an 8 million barrels per day supply reduction in the next 6 months, with an 85% probability of no supply interruption in the baseline scenario:

Following Brent crude oil prices just breaking $90 per barrel and the International Energy Agency (IEA) releasing higher-than-expected inventory data last Friday, our pricing framework indicates that the Brent crude oil 1-month futures price spread compared to the 36-month futures price (i.e., the 1/36 spread) is about $10 per barrel higher than the model predicts.

Goldman Sachs stated that although the likelihood of a disruption in oil supply through the Strait of Hormuz remains low, if the oil transportation through the Strait of Hormuz, which accounts for 17% of global oil production, is blocked, oil prices could rise by 20% in the first month. If the disruption continues for several months, oil prices could double