The dark cloud of Middle East war is once again looming over financial markets. While the shock of the initial U.S.-Israeli strikes on Iran is unlikely to be replicated, barring an alarming twist like a U.S. ground invasion, geopolitical risk is back on investors’ radar. Relief from falling oil prices and easing inflation pressures following the US-Iran ceasefire struck in April has evaporated. As flimsy as that ceasefire was, investors took it as a green light to rebuild exposure to risk assets and position for renewed economic growth. Now, Washington and Tehran are attacking each other with increasing ferocity, the conflict risks spreading across the region, and the prospects of either side backing down seem limited. Right now, escalation seems more likely than reconciliation. In some ways, the economic risk that poses is arguably even greater than what the world faced when the war started five months ago. Oil inventories are substantially lower now, and refining capacity is heavily constrained.
“Central banks and financial markets are again facing the negative supply shock scenario, which they had hoped to have escaped when the US and Iran signed the interim deal in mid-June. Stagflationary impulses are back,” Barclays strategists wrote on Monday. Wall Street has so far largely shrugged this off, focusing instead on the bullish AI and corporate earnings narratives. While chip stocks continue to be volatile, the S&P 500 is still within 2% of its all-time high from June 2. And credit markets have rarely seemed calmer, with high yield U.S. bond spreads around the tightest since the Global Financial Crisis.
Yet some markets – Treasuries, the dollar, and especially energy – are beginning to stir. Should the conflict continue escalating, those dynamics could easily spill over into stocks and corporate bonds.
RISK PREMIUM RISING
The market most affected so far is, unsurprisingly, oil. The last few weeks have reminded the world that a significant risk premium must be embedded into crude prices as long as Iran retains the ability to shut the Strait of Hormuz to tanker traffic. Brent and WTI crude futures have shot up around 30% in the last few weeks, and worryingly for policymakers as well as businesses and consumers, oil is now up 25% year on year.
Average prices at the pump in the US are also back above $4 a gallon, a psychological threshold for gas-guzzling Americans, especially in the mid-summer “driving season.” In light of all this, the prospect of a Federal Reserve interest rate cut this year has surely diminished. Indeed, the chorus of warnings from Fed officials that rates might need to be raised got notably louder last week.
Bonds are beginning to feel the heat. Yields have risen across the curve in recent weeks, as the so-called ‘term premium’ has spiked higher. That’s essentially the compensation investors demand for buying longer-term Treasuries over short-dated debt. While the term premium on the 10-year Treasury note tumbled to 0.46% at the end of June, its lowest in over a year, it has since spiked back up towards 0.70%.
SUMMER HEAT
Trump, conscious of his dismal approval ratings, may seek to do whatever it takes to end the war and get fuel prices down before the U.S. midterm elections in November. But with an emboldened Iran showing little willingness to budge on its demands, a timely resolution to the conflict may not totally be in Trump’s control.
Still, the “glass half full” view is that both sides choose peace – whatever that means – while they still can, either to avoid bloodshed or because of financial and economic considerations. In this scenario, the Strait of Hormuz gradually reopens, energy markets normalize, and global inflationary pressures cool.
Mark Zandi, chief economist at Moody’s Analytics, is cautiously optimistic this will play out in the coming weeks, perhaps by the end of August. If not, the risks are huge.
“By our calculation, unless there is a resolution to the war by Labor Day, (oil) inventories will fall so low that oil prices will spike and there will be physical shortages of refined products across the globe. Given the economic and political damage that this will cause, we expect President Trump and the Iranian regime to come to terms by then,” he said on Monday.
It’s already been a hot summer. It could be about to get even stickier for markets.
(The opinions expressed here are those of Jamie McGeever, a columnist for Reuters) Enjoying this column? Check out Reuters Open Interest (ROI), your essential new source for global financial commentary. Follow ROI on LinkedIn, and X. And listen to the Morning Bid daily podcast on Apple, Spotify, or the Reuters app. Subscribe to hear Reuters journalists discuss the biggest news in markets and finance seven days a week.
(By Jamie McGeever; Editing by Chizu Nomiyama )