Market Reaction to the Middle East

The financial markets have taken their finger off the panic button. Israel’s actions in Lebanon and the Gaza Strip are inspiring confidence, at least compared with where sentiment was a week ago.

Investors recognize that Israel is doing the world a huge favor by defanging Hezbollah and Hamas. These terrorist groups have long held Middle East peace and prosperity hostage to their suicide bombings, missile attacks and their insane demands for the eradication of the Jewish state.

The dollar and stocks are up from where they were just days ago when geopolitical jitters got the better of many market participants. The Dow is up over 200 points today, with the S&P 500 and Nasdaq following suit. Even the Israeli shekel has firmed and the Tel Aviv stock market has turned up, as have Arab bourses, indicating that the fighting in Lebanon and Gaza is being put into a larger, more favorable perspective.

Of course, any widening of the theater of warfare, such as direct military action against Syria, would likely be received nervously. Even though many on Wall Street know that something must eventually be done to stop Syria and Iran from further destabilizing the region and using terror groups as proxies in their fight against Israel, stocks would likely head lower, at least in the short run. Similarly, were Tel Aviv to be struck by missiles, the financial markets would also respond poorly, despite the fact that such an attack would surely redouble Israeli efforts to take out all of Hezbollah’s offensive capabilities.

Domestically, the Fed’s got one more rate hike to go at its next policymaking meeting on Aug. 8. The increase in the Fed funds rate is needed to defend the dollar, quell inflation expectations and stop the small up-creep in inflation.

While the rate hike would complete Fed Chairman Ben Bernanke’s policymaking task for the rest of this year and into 2007, he and Treasury Secretary Henry Paulson still need to speak up in defense of the greenback, making clear their commitment to a strong and stable dollar. This is especially important in light of the international tensions in the Middle East, Persian Gulf, Korean Peninsula and Indian subcontinent that have added new geopolitical risk not just to the dollar, but also to commodities and a bunch of leading currencies.