* Market correlations break as bonds and stocks fall together
* Dollar and oil only winners as Iran and oil risks rise
* Money market funds attract heavy amounts of cash this week
By Suzanne McGee, Dhara Ranasinghe and Samuel Indyk
LONDON/NEW YORK, March 3 (Reuters) – Cash became king in global markets on Tuesday as an escalation in the Middle East conflict dragged down gold, bonds and stocks synchronously, upending the normal interplay between safe and riskier assets and driving up volatility.
The turnaround in market sentiment, which just a day earlier was premised on a swift end to the conflict, came as Israel attacked Lebanon, and Iran responded with strikes against energy infrastructure in Gulf countries and tankers in the Strait of Hormuz, through which a fifth of the world’s energy passes.
Aside from higher oil prices and the U.S. dollar, most major stock markets, Treasuries and other bonds and even safe-haven gold were sold.
“What is happening is a classic response to an event that has a lot of uncertainty,” said Michael Arone, chief investment strategist at State Street Investment Management in Boston.
The decline in gold prices – they were down 4% after being at four-week highs on Monday – showed the indiscriminate nature of the selling, Arone said.
“Oil, and the dollar, are the only two things that people want to own right now,” he said.
Brent crude gained nearly 7%, while the U.S. dollar posted sharp gains, hitting multi-month peaks against the euro, sterling and yen.
Bonds and stocks moved in sync. Wall Street’s main indexes fell more than 2% on Tuesday, with the S&P 500 hitting its lowest in over two months, while the two-year U.S. Treasury yield hit 3.599%, its highest since late January.
Market analysts pointed to a host of factors driving the de-risking behaviour, including complacency about the conflict, extreme positioning in the weeks leading up to Saturday’s attacks on Iran, and the hit to bonds from the inflationary impulses higher oil would generate.
“History tells us that, in periods of stress, the correlation of cross-asset volatility tends towards one,” said George Adcock, head of trading and the deputy portfolio manager of Kohinoor Strategy at 36 South Capital Advisors.
Developments in the Middle East had caused investors to price various outcomes in markets, leading to a spike in volatility and pressure on extended positions in assets such as oil, gold and the dollar, Adcock said.
“During January we observed entrenched negative narratives, extreme positioning and subdued volatility. These factors are now unwinding reflexively that is leading to a significant VAR and correlation shock across many portfolios,” he said.
A VAR or value-at-risk shock typically occurs when selling is contagious across market sectors, breaking down the inverse correlations that had diversified risks and protected parts of investor portfolios.
LSEG Lipper data showed global money market funds received $47.9 billion in inflows, the highest since February 17, as investors sought refuge in short-term cash-like instruments.
By contrast, investors reduced exposure to equities, pulling $9.6 billion from U.S.-focused equity funds, while global equity funds witnessed an outflow of $9.1 billion on Monday, the highest in more than two months.
“There’s an interesting flight to quality happening, with the dollar rallying, but it’s not going to Treasuries or other dollar assets,” said David Kelly, chief global strategist at JP Morgan Asset Management. “That’s indicative of growing demand for short-term cash.”
Aakash Doshi, head of gold strategy at State Street Investment Management in New York, said billions of dollars had gone into listed gold funds this year, and outflows had been small on Monday but could potentially be sizeable.
“I think in the case of gold, you’re seeing some profit taking, and you’re seeing just some liquidity, a cash raise, using gold as a liquid alternative hedge, in order to potentially offset margin calls, to offset stopped-out long positions and so forth.
“The focus has to be on the immediacy of when there’s a real geopolitical shock or when there’s very massive market uncertainty; your cash is king still,” Doshi said.
While no one’s sure when the uncertainty will ebb, JPMorgan’s Kelly expects the dollar rally may not have legs, particularly if the conflict worsens the outlook for the fragile U.S. fiscal position and economy.
“Wars start out in shock and awe and end up in quagmire, which tends to be negative for the dollar,” he said.
(Additional reporting by Dhara Ranasinghe and Patturaja Murugaboopathy; Writing by Vidya Ranganathan and Nick Zieminski)
