Fears of wider Middle East turmoil lift oil prices, add to inflation

“The market remains very sensitive to the risk of further ramifications from the Israel-Hamas conflict, suggesting volatility – particularly in the energy sector – is likely to remain elevated, with Iran a major concern,” said Rodrigo Catril, an FX strategist at National Australia Bank.

While Israel is not a big oil producer, there are concerns that if the conflict spreads, it could hurt Middle East supply and worsen an expected deficit for the rest of the year.

The conflict could also derail US efforts to improve the relationship between Saudi Arabia and Israel and any associated increase in output next year, and also intensify US sanctions on Iranian oil exports. But despite its long history of funding and arming Hamas, Tehran denied its involvement in the attack.

The uptick in oil prices, which are still 8 per cent below their September peaks, add to already elevated cost pressures, stoking speculation that central banks could keep interest rates high for longer.

But David Bassanese, chief economist at BetaShares, argued that elevated oil prices should have only limited implications for the Reserve Bank.

“On the one hand, higher oil prices add to inflation, as petrol accounts for around 4 per cent of the [consumer price index] and prices rise by around 4 per cent for every 10 per cent rise in world oil prices,” he said.

“But on the other hand, rising oil prices also crimp demand and the more households spend on petrol, the less they can spend elsewhere.”

On Tuesday, a NAB survey showed cost pressures cooled in a welcome sign for the inflation outlook, suggesting interest rates may have peaked.

Independent economist Stephen Koukoulas said the results were “the nail in the coffin” for the rising interest rate scenario.

“It’s obvious that inflation will fall back to the target much sooner than the RBA is currently thinking,” he said. The RBA forecasts core inflation to slow to 3.9 per cent by the end of the year, from 5.9 per cent currently.

$A perks up

Traders trimmed rate rise expectations with bond futures implying a 45 per cent chance of an increase by May next year to 4.35 per cent. That compares with 52 per cent on Monday and 74 per cent last week. They also reintroduced the chance of a rate cut, ascribing a 31 per cent chance by December.

Goldman Sachs’ Andrew Boak still believes the next rate move for the RBA will be higher next month after the release of key quarterly CPI data on October 25 and the likely upgrade of the central bank’s growth and inflation forecasts.

The Australian dollar stood taller on Tuesday, having regained some territory above the US64¢ mark, despite investors’ flight to safety following the sudden escalation in the Israel-Palestine conflict.

The local currency popped to a one-week high of US64.33¢ as the greenback softened on cautious comments from US Federal Reserve officials about the need for further tightening. If sustained, it would be the fifth consecutive session of gains for the Aussie, which was trading at US64.09¢ late on Tuesday.

The Aussie dropped to an 11-month low of US62.83¢ last week and has shaved off 5.8 per cent this year, largely on interest rate differentials between the US and Australia.

Also helping the $A is a small reduction in speculative short contracts by fund managers. Real money accounts trimmed net shorts in the Australian dollar to 82,100 contracts the week to October 3, from 96,700 contracts the prior week.

This came as hedge funds increased their negative views on the Aussie with net shorts of 13,900 contracts, from 9100 the week before. Sean Callow, a senior FX currency strategist at Westpac, noted the overall $A position remained “heavily bearish”. Using CME data, he said speculators’ net short positions stood at nearly $10 billion.