Difficulty in predicting ups and downs? Middle East conflicts disrupt financial markets and traditional asset signals completely fail.

Since the outbreak of the conflict in the Middle East, traditional global asset correlations have ceased to function, and have not been restored so far. Investors seem to be facing a malfunctioning dashboard, piecing together trading strategies and trying to grope their way towards a clearer path. While the U.S. stock S&P 500 index has repeatedly hit new all-time highs, it has sharply deviated from the severe geopolitical risks, continuous threats of energy supply disruption, and lingering concerns about long-term economic damage. Mark McCormick, Chief Foreign Exchange Strategist at BMO, believes that in the next three to six months, the market will bid farewell to the normal state of affairs before the conflict. He pointed out in his research report: "Although economic growth momentum has picked up somewhat, it still falls short of the level at the end of 2025; the pressure for monetary policy tightening remains high, asset correlations continue to be restructured, asset withdrawal risks keep rising, and a completely new market structure is gradually forming." This article will focus on stocks, bonds, foreign exchange, and commodities, analyzing the current state of rupture in the traditional market linkage logic these types of interrelationships have always been a core reference basis for predicting economic trends. Fixed income market faces severe tests Under normal market conditions, stock market and bond yield trends often move in the same direction. Due to concerns about economic downturn risks, investors may increase holdings of bonds for hedging, thereby affecting the stock market and lowering yields; the logic is completely reversed when the economy is doing well. However, since the outbreak of the pandemic, this linkage model has been consistently disrupted, as high inflation and high government debt have continuously weakened the traditional hedging function of bonds against stock market risks. The International Monetary Fund warned in a blog post released in February, prior to the outbreak of geopolitical conflict, that investors and policymakers must rethink risk management in a "new era" where traditional hedging measures have failed. Short-term sovereign bonds, which are highly sensitive to inflation and interest rate expectations, are now at the core of this round of market turbulence. Over the past five years, the average monthly rolling correlation between the U.S. two-year Treasury yield and the S&P 500 index has dropped from a mean of 0.23 to around -0.8; since the conflict erupted, this data has remained stable at -0.63. The correlation between the German two-year bond yield and the Euro Stoxx 600 index has also exhibited a highly similar divergent trend. Michael Metcalfe, Head of Macro Strategy at DWS, said: "According to past patterns, during the market turmoil in March, short-term sovereign bonds should have seen an inflow of funds, but this did not happen." "This shock is a severe test for the fixed income market because it is both an inflation shock and a growth shock, which further amplifies concerns about the long-term fiscal outlook." Unusual trends in gold After the outbreak of the geopolitical conflict, gold completely lost its classic safe haven asset attribute, showing an unusual correlation with stocks, high-volatility cryptocurrencies, and currently trading about 10% below its pre-conflict peak. Traditionally, gold has maintained a highly negative correlation with the U.S. dollar for a long time. When market volatility intensifies and funds collectively sell off risk assets such as stocks and bonds, the dollar often becomes the core safe haven choice, which is also the case during this conflict. Since the end of February, the correlation between gold and the U.S. dollar has narrowed from a five-year average of -0.4 to -0.19; while the correlation between gold and the stock market has risen to 0.55, far above the average level of 0.22 over the past five years. This may reflect more extreme changes in the correlation between the dollar and the stock market: this week, the correlation between the two fell to -0.94, almost completely negative, while the five-year average was only -0.28. At the same time, the correlation between bitcoin and the U.S. stock market soared to a historic high of 0.96, significantly higher than the pre-conflict average of 0.4, completely undermining the value of cryptocurrencies as a risk diversification in asset portfolios. Extreme events giving rise to abnormal market effects The rising risk of inflation prompts traders to factor in rate hike expectations (especially in Europe), while U.S. rate cut expectations have significantly cooled. Typically, diverging monetary policies between regions will directly drive differences in currency strengths, but this classic logic has also failed. The market generally expects the European Central Bank to raise interest rates twice this year, while the Fed is leaning towards rate cuts. However, the Euro's exchange rate against the dollar has barely stabilized around 1.17, with the exchange rate losses from the conflict almost unrecovered. UniCredit stated: "Major unexpected events can reshape the logic of financial markets, overturning the traditional correlations between various assets and economic indicators; the decoupling of the Euro against the dollar from interest rate differentials is a typical example." Using the Eurozone-U.S. two-year interest rate spread as a benchmark, the current correlation between the spread and the Euro exchange rate has risen to 0.5, compared to almost zero at the beginning of the year, and an average of -0.3 over the past two years. UniCredit added: "Until the risk premium created by the geopolitical conflict completely fades away, it is difficult for the Euro-U.S. rate spread to become the dominant factor driving the Euro's exchange rate again." Inflation expectations diverging from fundamental anchors Traditionally, a rise in oil prices directly pushes up market inflation expectations, but during this conflict, despite a significant increase in oil prices, long-term inflation expectations have continued to decline. The five-year/five-year forward inflation swap rate, which measures U.S. long-term inflation expectations, has fallen from around 2.45% to around 2.4%, while oil prices have accumulated gains of around 40% during the same period. The correlation between the two has dropped to -0.7, significantly deviating from the average of 0.2 over the past five years; in contrast, during the 2022 Russia-Ukraine conflict-induced energy crisis, this indicator briefly rose to 0.7. Analysts at Deutsche Bank pointed out that the increase in U.S. fiscal spending and widening fiscal deficits due to the geopolitical conflict are partly to blame for the reversal of the inflation logic. "However, another possibility is that forward inflation pricing has become increasingly detached from fundamentals," the bank stated.