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Threat of Middle East conflict triggers flight to safer assets, IMF warns

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The risk of a broader conflict in the Middle East threatens to reverse a surge in the price of riskier assets since the start of the year, the IMF’s top financial stability official has warned.

The fund’s Global Financial Stability Report, published on Tuesday, said expectations that the world economy would avoid a much-feared recession had driven up prices in assets such as stocks and lower-grade bonds since the turn of the year.

“At the beginning of the year we saw a lot of optimism in markets. There was this expectation of a soft landing globally, of inflation coming back to target,” said Tobias Adrian, director of the fund’s monetary and capital markets department. Lending costs had fallen “substantially”, he added, especially for higher risk borrowers.

But Adrian told the Financial Times that the recent “risk-on” rally could soon be over. Global stock markets sank and Asian currencies fell on Tuesday amid waning hopes for rapid US interest rate cuts and fears over an escalation of tensions in the Middle East.

Heightened tensions between Israel and Iran had already triggered a “classic flight to quality” assets, such as US Treasuries, away from stocks. On Friday, the 10-year US Treasury yield — a key barometer of global borrowing costs — fell from 4.56 per cent to 4.5 per cent, while equities fell.

Adrian said oil prices would be a crucial factor in determining the outlook for financial stability. Benchmark Brent crude has fallen slightly but remains close to $90 a barrel, having risen more than 6 per cent over the past month.

Line chart of  showing Oil prices have been rising this year

“The risk is that [higher] oil prices lead to a further run-up in commodity prices more broadly, which pressures inflation and then triggers a change in stance for monetary policy and would lead to an impact on valuations more broadly,” he said.

Adrian said he also expected supply chain disruptions to hit oil importers, such as most European countries, harder than producers such as the US.

The US and its European allies have tried to dissuade Israel from striking back after Iran launched drone and missile attacks in retaliation for an Israeli strike on its diplomatic compound in Syria. However, Israel has signalled that it is likely to respond, risking a full-blown Middle East conflict.

Such a scenario, Adrian said, would invite further “questions around the level of valuations and the level of [debt] issuance we have seen”.

“That could ultimately impact financial stability and downside risks,” he added.

While the IMF’s central scenario remains a soft landing for the global economy, Adrian said how restrictive monetary policy would need to remain to fully rein in price pressures was now “the key question”.

After raising rates sharply in 2022 and 2023 to tackle the worst bout of inflation for a generation, central banks on both sides of the Atlantic are expected to cut rates in the coming months.

However, that outlook for global borrowing costs would be challenged should disinflation prove unexpectedly slow — or go into reverse, as investors fear.

“Stalling disinflation could surprise investors, leading to a repricing of assets and a resurgence of financial market volatility,” the GFSR said.

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