Global markets have been glued to headlines from the Middle East over the past week, with oil prices rising close to $120 a barrel on Monday before temporarily falling below $90, hoping the conflict might be nearing an end following statements by President Trump.
However, it seems to us that even if the United States were to decide it has done enough to declare its objectives achieved, it is unclear whether this would immediately lead Iran to agree to talks and a cessation of hostilities.
The war against Iran appears existential for the IRGC (Islamic Revolutionary Guard Corps) and other elements of the regime and, from this perspective, surrender has never seemed an option. Consequently, it seems Iran may decide to relent only after inflicting much greater pain on the global economy, hoping this will shift regional balances, seeking to remove the US presence from the Gulf.
From the Iranian point of view, this may seem the only leverage tool the Tehran administration can use to ensure its long-term survival. If this is the case, it could leave the US and its allies without an easy way out of the current conflict other than trying to complete what was started through military means.
However, beyond the broader geopolitical implications regarding the trajectory of this war, more specifically, from the financial markets’ perspective, the only thing that really matters for the global economy is the bottleneck in the Hormuz Strait. Simply put, if oil can continue to flow, any economic disruption could prove short-lived.
However, the longer the transit remains blocked, the more fields will have to be shut down as storage capacity reaches its limit. A global shortage of crude oil and related products could cause prices to soar, and once reserves are depleted, there will be a limit to what the IEA (International Energy Agency) can do, except in the very short term.
The Strait itself is literally a very narrow passage, and although military stocks and security guarantees can be provided, the reality is that slow-moving bulk oil tankers represent an easy target for low-cost drones and small boats. This low-cost, low-tech warfare can therefore maximize disruptions with minimal expenditure.
So far, although it seems US/Israeli forces have made progress in eliminating ballistic missile launchers, mitigating the drone threat is proving much more difficult given their ease of deployment and low cost.
Consequently, it seems reasonable to assume that transit could be seriously compromised until Iranian capabilities are eliminated, or until the IRGC is persuaded to enter some form of talks aimed at de-escalating the current conflict. Of course, such a breakthrough could happen relatively quickly.
However, our general feeling is that this situation suggests attacks will likely persist for at least another month or two and that during this period oil price risks will remain skewed to the upside.
Moreover, in addition to being responsible for 20 million barrels per day of crude oil, representing 20% of global consumption, it is also worth noting that the Hormuz Strait is responsible for the transit of 20% of global LNG exports, 25% of global fertilizer exports, and 35% of urea exports.
In this context, its closure, even temporarily, represents a global stagflation shock. For example, fertilizer deliveries blocked today will likely mean poorer harvests later in the year, putting upward pressure on food prices. Subsequently, in attempting to assess the aggregate inflationary impact, much will depend on how long trade remains compromised and the ability to reroute some of this production through other transit points.
However, our initial assessment is that it seems reasonable to think CPI inflation readings could temporarily rise by about 1%, while at the same time about 0.5% would be shaved off growth projections.
Regarding central banks, we consider it very unlikely that the Federal Reserve, under future Chair Warsh, will be persuaded of the need to raise interest rates in light of these macroeconomic developments. We think rate cuts are still possible later in 2026 if the conflict clears up in the next two months and oil prices fall, allowing policymakers to look beyond higher short-term inflation data.
Similarly, we note that the Bank of England entered this conflict with a weakening economy and a monetary policy stance leaning towards easing. Were it not for recent developments, we would have expected a BoE rate cut at the end of March meeting and, although we no longer see this possibility, we think it will take a lot for the BoE to shift towards a rate hike agenda.
As for the Fed, we believe this could mean monetary easing remains on the agenda later in 2026. BoE models, which largely rely on output gap analysis, also tend to indicate the need to ease policy prospectively rather than tighten it.
The context for the ECB could be quite different. Here the institution is more sensitive to a short-term inflation increase, having acknowledged that in 2022 its biggest mistake was waiting too long before starting to raise rates. There is therefore a mindset that raising rates early will mitigate the overall amount of monetary policy tightening subsequently required and then allow rates to fall more quickly.
In the US, this month’s CPI release was in line with expectations, with core prices at +2.5% year-on-year. However, economic data are currently taking a backseat, with US yields not reacting to a weak labor market report last week, showing job contractions and rising unemployment.
However, AI disruption in the labor market is a theme that must continue to be closely monitored. Meetings with senior executives of US banks this week suggested a planned workforce reduction of up to 30% over a three-year horizon. Such a rapid job replacement could represent a significant negative economic risk at the macro level if such outcomes occurred on a large scale across various sectors.
This serves as a reminder that, although in the short term the Middle East conflict seems to be all that matters, the big themes related to AI, and what they will mean for economies, societies, and asset prices, have certainly not disappeared.
Last week saw strong volatility in short-term interest rate contracts, especially in Europe. While these moves are partly justified by changing fundamental contexts, it is clear that price action was amplified by stop-loss closures of some large consensual short-term rate positions and yield curve steepening trades.
In light of these moves, we took the opportunity to concentrate our rate exposure in the UK on the short end of the curve, where we believe it is wrong for markets to price higher UK interest rates. Additionally, we also used a flattening of the US Treasury curve as an entry point into steepening positions.
One thing that strikes us is that, in a more stagflationary environment, governments globally will likely ease fiscal policy in an attempt to mitigate voter pain from rising energy prices. This represents an additional source of potential fiscal deterioration, which could lead curves to price higher term premiums. Moreover, recent events are making increased defense spending even more urgent, and this too is a factor pushing in the same direction.
Currency market moves have been much more modest compared to rates over the past week. The dollar has continued to strengthen across the board, but outside of moves in emerging market currencies, the moves have seemed lacking strong conviction. We continue to hold few strong convictions on FX at the moment and, although the yen has reached our target levels near Y160, we do not think this is the environment to go long on the Japanese currency.
More generally in Japan, we reduced duration risk last week, as we think Takaichi will be more inclined to try to ease policy to mitigate downside economic risks. However, we continue to hold a long-term conviction on the 10-30 year curve flattening in Japan.
Credit spreads have followed equity moves, with corporate bonds trading relatively orderly. In investment grade, spread widening following the general risk-off was partly amplified by continued and substantial new corporate debt issuance. Amazon was the big issuer of the week, with a new $37 billion US issuance helping make this Tuesday a new record day for issuance in the US IG market, with a total of $66 billion of new issuance priced. As hyperscalers show no intention of cutting their investment spending, we are likely to continue to see a steady flow of new issuance in the market over the coming months, and this remains a headwind for spreads.
In contrast to corporate credit, price action in emerging markets showed greater signs of excess last week, with investors in that universe more inclined to sell first and ask questions later. On a relative basis, oil exporters performed better than energy importers, although in many respects we believe markets have not sufficiently differentiated between relative winners and losers in a declining market.
Elsewhere, private credit continues to generate negative headlines, with JPMorgan as the latest bank to write down values in this asset class. As previously noted, high leverage in private markets has made investors in this sector eager to see lower interest rates but, with these hopes fading and rising credit impairments, further difficulties may lie ahead for investors in these vehicles.
In this regard, it is also noteworthy the extent of exposure in these funds by investors from the Middle East region. While we do not expect redemptions in the short term, it seems very unlikely that new capital will be recycled into new investments by this investor base in the near future, and this could add further difficulties to the technical backdrop of private markets if leverage is compressed.
LOOKING BACK, LOOKING FORWARD
Returning to the conflict with Iran, it is striking that Europe, as a whole, is a bystander to ongoing events and appears rather inept and irrelevant. In the UK, this was exemplified by the delayed deployment of HMS Dragon, the only British warship with anti-missile capability. Having been stuck in port until the end of this week, it gave rise to the joke that this ship represents the only “small boat” this Labour government has actually managed to prevent from crossing the English Channel!
As for the US administration, a growing question in the coming weeks will be whether Trump’s bet on Iran is starting to backfire. Despite Trump’s attempts to calm markets and convey the idea that everything is proceeding according to plan, many will wonder whether there was ever really a plan from the start. Certainly, history has taught us time and again that it is much easier to start a war than to end it.
