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The "Fear Trade" That's Back in Play

The "Fear Trade" That's Back in Play

Kathy Lien, Technical Strategist

Widespread risk aversion caused by the conflict in Syria has caused risk assets like equities and high-beta currencies to sell off furiously, driving the US dollar, gold, and oil higher in the process.

The simultaneous selloff in stocks, and rise in the US dollar (USD), gold, and oil prices tells us that investors are nervous about the situation in Syria. The possibility of a military strike on the nation is growing by the minute, and investors are worried that it could destabilize the region.

Widespread conflict in the Middle East has already caused havoc in the region, but this time, the world's oil supply could be impacted. Syria borders Iraq and is an ally of Iran, two countries that constitute nearly one-fifth of total OPEC production. At the same, the risk of war always makes investors nervous, and it is coming at time when there are already concerns about the debt ceiling and the drag that Fed tapering could have on the US economy.

Up until this month, investors around the world were quietly putting on risk trades after better-than-expected economic data sparked confidence about a stronger second-half recovery. While the resilience of the EURUSD suggests that hope is still alive, the “fear trade” could be coming back from dead. The simultaneous rise in the dollar and gold is a clear sign that there is a flight to quality, while the rise in the Japanese yen (JPY) signals liquidation of carry trades.

We don't know how quickly the Obama administration will decide to act on Syria, but the level of uneasiness in the markets will probably worsen before it improves, leading to a deeper selloff in equities, strength in safe-haven assets, and weakness in emerging market currencies.

See also: 2 Lesser-Known Currencies Collapsing Big

Syria has already threatened to retaliate and defend itself in ways that could "surprise" the world, according to the country's foreign minister. While Syria is not a major exporter of oil, oil prices hit one-and-a-half-year highs on fears that attacks on Syria could affect major suppliers in the region.

Gold prices also rose to the highest level in three months as investors sought other assets for safety. If there is an international military strike on Syria, we could see more panic selling, but if there are signs of a swift victory or resolution, order will be restored, paving the way for a relief rally.

The price action in the financial markets today is a classic example of how geopolitical risks can overshadow economics and how thin trading conditions can exacerbate movements in the financial markets. While US pending home sales are scheduled for release tomorrow, the focus will remain squarely on Syria.

See related: A New FX Risk That Trumps All Others

The Lone Commodity Dollar That Held up

Of all the major currencies, the one that held up best in the face of widespread selling was the Canadian dollar (CAD), which ended the North American trading session unchanged against the greenback thanks in large part to the rise in oil prices.

The move that we have seen in oil could be just a taste of how much crude could rise if Syria is attacked. The Canadian dollar's correlation with oil prices has been shaky this year, but on a day when fear was driving prices, the rise in oil was enough to lend support to the loonie. At the same time, however, 1.06 in USDCAD will be a tough level to break, and the move in oil gives the pair even stronger reason to fail at this price.

The Australian dollar (AUD) and New Zealand dollar (NZD), on the other hand, experienced steep losses that would have probably been worse if not for the rise in gold prices. No economic data was released from any of the commodity-producing countries today, but data from China was slightly better than expected. While industrial profits held steady last month, China's leading index ticked higher.

Australian housing market data and Canadian average weekly earnings are on the economic calendar for Wednesday, but these are second-tier reports and are not expected to have measurable impact on commodity currencies.

By Kathy Lien of BK Asset Management

DailyFX provides forex news and technical analysis on the trends that influence the global currency markets.