Economics vs geopolitics: does the wolf finally bite?

The Iran war is heavily disrupting commodity and financial markets and causing broader shockwaves across the global economy.

The oil price is up from ~$US70 a barrel to ~$US110 a barrel (chart 1). Reflecting higher inflation risks, 2-year US bond yields have jumped by ~40 basis points to ~3.80% (chart 2) and expectations of further interest rate cuts are being pared back. Equity markets are also down, some by almost 10% (chart 3).

A ‘glass half-full’ approach

Despite these large movements, markets have again taken a ‘glass-half full’ approach to the crisis. They are implicitly betting that the conflict will not persist for too long and that oil and other supplies will again start to flow through the Strait of Hormuz.

This has been a common pattern in recent years, with markets repeatedly ‘looking through’ shocks. As Vivek Dhar outlined, the current degree of disruption to global oil markets is unprecedented in two ways: the extent of supply sidelined and the lack of spare capacity.

The famous 1970s oil shocks caused by the Arab oil embargo and the Iran revolution affected only around 5-7% of global oil supply; today around 15% is at risk. In the 1970s, global spare oil capacity was around 5-8%; today it is lower at around 3-5%.

If sustained, an oil shock of this scale would easily justify higher oil prices than $US110 a barrel; more realistic is $US120-$US150 a barrel. At that price, the impact on global inflation and demand would become far more severe. And it is not just oil that we need to consider. Many other critical goods are also affected, such as LNG, urea, sulphur and ammonia used in fertilisers, Helium used in semi-conductor production and aluminium.

So, why are markets still relatively calm? There are two dominant investor views. First, is the view that the global economy cannot sustain oil prices at $US150 a barrel, so it would be untenable for the US Government not to act to ease the conflict; the economic pain is just too great.

Second is the TACO (Trump always chickens out) narrative. The US tariff backdowns of 2025 are still front of mind for many investors. In that case, President Trump overreached and was pulled into line by US bond markets. This reinforced the view that economics ultimately trumps geopolitics.

The stakes are higher this time around

It is true that a sudden reversal and US exit from the conflict can’t be ruled out. President Trump has the personal audacity (or “chutzpah”) to declare victory at any time, whatever the reality. But in this case, the political and security costs of a backdown are far greater.

Let us say that the US withdraws while the Strait of Hormuz still remains closed and without a clear ‘prize’, such as some form of regime change. The Iran regime (and its proxies) will be emboldened.  More importantly, their defensive strategy will be validated. This strategy is based on: 

• raising the economic and political cost of the war by cutting shipping through the Strait of Hormuz;
• applying regional pressure by striking US bases and allied infrastructure in neighbouring countries; and
• attacking highly visible and symbolic economic targets such as major international airports in the Gulf.

If the US withdraws it will be a concession that this strategy works. This will invite further Iranian attacks on US allies and interests; severely limit US leverage in any future negotiations with Iran, including over their nuclear program, and likely drive more oil supply disruptions over time.

The security officials in Washington (and Israel) are acutely aware of this, so they will want a more decisive outcome. They will want to prove to the world that they can underwrite safe transit through the Strait and/or win a more decisive military or political victory. As Madison Cartwright argues , this won’t come easily. Even if it can be achieved, it will take time.

Holding back the tide

Noting the need for a more decisive military outcome, and the reality that this will take some time to achieve, what can the US do in the meantime to reassure markets and limit the near-term economic damage?

• They can ‘jawbone’ by talking up their military achievements and flagging an early or imminent end to the war.
• They can work with allies to release oil stockpiles and increase supply where possible, including easing Russian sanctions.
• They can focus their efforts on securing shipping access through the Strait by degrading Iran’s offensive capability and increasing naval assets in the region to assist with escorting vessels.

This is exactly what the US has been doing. These actions, particularly the recent decisions to ease sanctions on Russian oil, confirm that the US is expecting a longer, and more drawn-out conflict.

Will the dam break?

To date, this strategy has prevented larger increases in the oil price and kept a lid on broader financial market damage. However, if as expected, the war drags on, we expect this strategy will wear increasingly thin. We therefore judge there is a strong likelihood of a further material market reaction in coming weeks - this could occur suddenly or gradually.

Furthermore, the longer the war lasts, the greater the risk of an accident or an escalation, such as the destruction of essential oil and gas infrastructure like a major processing facility, tanker terminal or pipeline. Any damage done to a US escorted vessel would also dent market confidence. These would spark a more sudden reaction across financial markets.

We have just seen an example of this with the recent air strike on Iran’s South Pars gas field, the largest natural gas field in the world, driving retaliatory attacks on the Ras Laffan LNG Hub in Qatar, the world’s largest LNG production/export complex. This saw Brent oil spike closer to $US120 a barrel before retracing back towards $US110 a barrel.

When the dam breaks…

This is a highly fluid situation; three main scenarios are possible.

• A sudden withdrawal by the US, leading commodities and global markets to settle back towards pre-war levels — reinforcing the view that economics still trumps geopolitics.
• A drawn-out conflict, but without further escalation and with some resumption of the flow of oil and other goods through the Strait of Hormuz with either US or Iranian backing.
• A drawn-out conflict with the Strait of Hormuz remaining blocked for some time and the ever-present risk of further escalation.

As things stand, we continue to judge that a more drawn-out conflict is the most likely outcome, with continued supply constraints in the near term. This suggests, investors should remain cautious and alert to the risk of a more severe scenario and market reaction.

What would a material re-pricing of market risk look like? As flagged, we could easily see the oil price move into the $US120-$US150 range. This is more consistent with an oil and energy supply shock of this size.

At these oil price levels, we would see a significant increase in headline inflation globally. We judge that central banks will want to err on the side of more restrictive monetary policy, not less, at least initially. This will be important to limit pass through to underlying inflation and to prevent inflation expectations from de-anchoring. In the near-term, this will override fears around demand and growth write-downs.

Since the war broke out, we have already seen expectations of further interest rate cuts pared back and, in some cases, replaced with an expectation of hikes (chart 4). As outlined by Joseph Capurso, pressure to hike rates will be most acute in countries already facing ‘sticky’ inflation challenges, such as the US and Australia.

This shock has again demonstrated that the US dollar remains a pre-eminent safe-haven currency, in line with our long-held view. The Greenback is also being supported by the US’s growing energy independence, in contrast to the high import dependency of China, Japan and Europe (chart 5). A higher oil price and stronger risk off sentiment will favour a higher US dollar, along with other safe-haven assets such as gold.

Share markets have dropped and there is much rotation between sectors, but financial markets have proved quite resilient to the moves in oil prices and emerging risks to growth. Credit spreads have barely budged and volatility hasn’t been as extreme as we saw after Liberation Day. 

To date, the direct inflation consequences of the war on bond markets has outweighed the impact of any flight to the safety of US Treasuries and other sovereigns, pushing US 2-5 year yields ~40 basis points higher. A prolonged conflict would point to a decline in real bond yields that could start to offset the rise in the inflation expectations component of nominal yields that has so far dominated. One complicating factor is that the rising cost of the war will likely add to bond issuance, limiting the ability of longer-term bond yields to fall. For capital markets, the volatility and uncertainty points to a slowdown in new bond issuance and wider credit spreads.

Our commodities, international, domestic and markets teams will all provide further detailed updates and forecasts over the coming days and weeks, unpacking the implications of these three scenarios for growth, inflation, interest rates, commodity prices and currencies.

It is still early days and circumstances can change rapidly, but on this occasion, geopolitics may trump economics, surprising markets.