US bond investors are now caught in a precarious situation as the threat of a wider war between Iran and Israel drags on, sending oil prices higher and the Federal Reserve keeping interest rates high for longer to fight inflation.
In a note on Monday, the uncertain region is not a good place for bonds, describing the current geopolitical backdrop in the Middle East as “neither severe enough to cause a flight to safety for bonds, nor deflationary enough to want to own bonds.”
Israel is reportedly weighing its response to an attack from Iran over the weekend, NBC reported Monday, citing an unnamed Israeli official. The news comes just days after Iran launched a retaliatory strike against Israel after it accused it of attacking its consulate in Syria.
If the current conflict de-escalates enough to lead to real peace, without a war of attrition and without the threat of a wider regional war in the Middle East, although highly unlikely, this would be deflationary because history shows that war is inflationary, NBC added.
“War requires more resources to be directed towards defence and war-making, causing supply chains to shift into less optimal configurations and consumers and businesses to stockpile,” Macquarie said.
The more likely scenario – neither a broader regional conflict nor a genuine peace – is a ‘war of attrition’, Macquarie estimates, saying that in this scenario, Israel, by avoiding a broader war, would be able to maintain a regional coalition against Iran.
In the ongoing war of attrition between Iran and Israel, “the threat of superpower involvement remains low,” limiting the possibility of a rush into safe-haven bonds, but the possibility of supply disruptions and higher oil prices, prompting the Fed to hedge against inflation, keeping US interest rates high for longer, is likely to depress bond prices.
However, if the axis of war tilts towards a much broader war – involving the superpowers – they would abandon their bearish bet on bonds, but reiterated that this was not the base case as they believe “an intensification of the ‘war of attrition’ would be more likely.”
Source: Investing
