Oil, Iran and why markets are staying calm

Despite Israel and Iran exchanging fire for a fifth day, markets seem to be completely disregarding the possibility of this conflict mutating into something serious for the global economy. Rates and risk assets have been somewhat more volatile than usual, but apart from oil trading around $10 per barrel higher than it was two weeks ago (leaving it pretty much flat year-to date), markets haven’t shown a particularly strong reaction to two major Middle East powers firing missiles at one another.

Is there a little bit of complacency? Perhaps, but at the same time there is a rationale for keeping calm and carrying on.

There are some specific channels in which this conflict could escalate, with the main one being through oil. If Iran was to close the Strait of Hormuz, through which around 30% of global oil transits regularly, the consequences would be dire. The current consensus is that this is unlikely because it would not necessarily benefit Iran directly and would also risk angering its oil-importing allies, China being top of the list. Another channel would be for Iran to attack US military bases in the Middle East, with the rationale being to send a message to the US if Iran believes it is assisting Israel’s military campaign. The counter argument is that these military positions are located in the Arabian Peninsula. Iran and its Arab neighbours have actually improved their relations in recent years, admittedly from a low starting point. It seems like a stretch for Iran to attack these countries’ territories given they have nothing to do with the current conflict with Israel, while at the same time dragging the biggest military power in the world into a conflict Iran is already losing.

Are markets right to completely disregard the possibility of a large escalation? We think not. The Iranian regime might be facing its most difficult time internally since the war with Iraq in the 1980s, with the economy performing very badly. Cornering an autocratic government that seems to be in trouble internally might bring about changes in the regime’s response function, so we cannot completely discard a nasty surprise of the sort mentioned above. We do believe the probability of these accidents is low, but it is not zero.

What does this mean for diversified fixed income portfolios? With tail risk events multiplying and credit spreads hovering around their recent tights, we think this is a time to be prudent and disciplined. The first thing that comes to mind with the previous sentence is to cut risk. However, it seems to us that many portfolio managers will have done this derisking already as spreads have tightened in recent quarters while yields remain high. If fixed income portfolios are not carrying excessive risk on average, that leaves a healthy technical picture. In other words, “everyone” has space to add risk. This suggests episodes of volatility should be relatively subdued as investors are relatively quick to “buy the dip”. Without a doubt this situation could change if a severe event happened, such as a negative shift on reciprocal tariffs or oil surging to $120 per barrel. But we think the event would have to be quite severe. For the most part, if portfolios are not carrying excessive risk, we don’t see an obvious need for portfolio managers to take many chips off the table.

Turning to rates, government bond yields have remained in their recent range albeit they have moved up from their recent lows. Government bond yields are typically shaped by investor expectations around economic growth and inflation. Crude oil prices – often seen as a barometer of these expectations – tend to influence bond markets through two main channels. First, oil prices reflect the state of the economy; when demand is strong, oil prices tend to rise, signalling economic momentum. Second, oil plays a major role in inflation; higher oil prices tend to push inflation up, while lower prices help to bring it down. That’s why falling oil prices can often signal both weaker economic activity and a softer inflation outlook, especially when driven by demand-side weakness. Historically, oil price movements have tended to move in line with government bond yields, though the strength of the relationship tends to change over time.

The effectiveness of government bonds as a risk-off hedge has been a key theme in recent months, with US Treasury (UST) yields facing upward pressure despite the growth risk presented by tariffs as investors have focused on inflation and, increasingly, the sustainability of government debt levels. The reaction of rates in this latest episode has again raised a few eyebrows, with USTs seeing a small rally when Israel first attacked Iran that has reversed rather quickly.

To the oil price dynamics, we have to add the growing fiscal concerns. If oil prices moved lower, there is reason to believe that a rally in USTs would not be as obvious or as large as if there were no fiscal concerns. If oil moved higher from here, the initial reaction would likely be a sell-off as markets anticipate fixed income’s worst enemy would rear its ugly head in the form of higher inflation. We would point out though that the correlation between 10-year UST yields and oil prices is not particularly high, though it is positive at 25% (using monthly returns for both since the early 1980s).

There is a point though when oil prices become a major issue for global growth, and given this would be a supply side shock, the Federal Reserve (Fed) and other central banks could be tempted to cut rates in spite of oil prices being high. The 2007/8 period is the best example of this situation, when oil prices doubled in 10 months to over $140 per barrel while at the same time the Fed cut rates from 5.25% to 2%.

Given we have favoured moving portfolios up in credit quality for some time, we keep calm and carry on. In times like these, it's paramount to remain disciplined with credit work and not be tempted to carry too much risk.