Liquidity Lowdown: The impact of the Middle East conflict on cash investors

Geopolitical tensions have a history of spreading a sense of panic around financial markets, but the initial reaction in money markets to the escalating war in Iran may have felt somewhat muted. 

Markets have developed a striking ability to almost ‘shrug off’ external shocks, yet the severity of the current situation, including attacks across the Gulf and the risk of prolonged supply chain disruption, may have made this conflict progressively more significant for short-term funding markets, which invest across multiple geographical regions.

Yields on money market instruments, like certificates of deposit (CDs) have risen since the escalation of the war, as there is concern that rising oil prices may increase inflationary pressures, and negatively impact global growth. One‑year CDs may have risen noticeably over a relatively short period of time which, for an asset which generally exhibits little unexpected price movement, might feel like a sizable move. The increase may reflect the market’s rapid reassessment of risk, with investors demanding greater compensation in an environment where energy-driven inflation could prove more persistent than anticipated.

The repricing is being influenced by rapidly shifting expectations around interest rate cuts. In the space of a week, expectations for the Bank of England (BoE) easing this year moved from two cuts to roughly half a cut being priced in. The upward pressure on short-term yields is consistent with markets adjusting to the prospect of higher for longer rates—an environment in which money market funds (MMFs) may see higher income distributions, even as underlying instruments reprice.

As uncertainty rises, investors naturally become more selective, favouring those issuers perceived to be most resilient to market shocks.

CDs issued by banks in regions such as Saudi Arabia and Qatar have seen the widest moves in spreads as money managers are becoming increasingly cautious of regional spillover and investing in regions with heightened risks. As uncertainty rises, investors naturally become more selective, favouring those issuers perceived to be most resilient to market shocks. 

Countries such as Japan and South Korea are highly dependent on crude oil shipments passing through the Strait of Hormuz, leaving them particularly vulnerable to prolonged disruptions. In the event of sustained pressure on energy markets, these economies may resort to fiscal measures to temper demand. For Japan, potential rate increases could flatten the yield curve and compress the net interest margins (NIMs) of banks.

Interestingly, though, the broader ‘flight to safety’ has clearly not unfolded in recent geopolitical developments, and rather than investors turning to MMFs or government securities, investors have instead turned to gold and commodities. These assets have traditionally acted as a hedge against inflation and energy-driven price pressures.

Despite these risks, MMFs continue to be considered by some investors due to their shorter duration and focus on diversification. The shorter duration of cash portfolios allows them to reset more quickly to higher prevailing yields, while their emphasis on diversification and high-quality credit can make them less sensitive to geopolitical events.

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