The missiles are again flying and a thick fog of
war has descended over the Middle East. US President Donald Trump has
said it might take four to five weeks or longer to achieve America’s
objectives, whatever those are. During a hot war, that’s an eternity in
the world of mercurial financial markets.
So far, however, markets have been remarkably sanguine, perhaps, as the excellent Yves Smith posits, because “bigotry
and Western narrative control were able to shore up the idea that this
would be a short conflict and that Iran would return to the negotiating
table after the US broke its legs, or better yet fall quickly into civil
unrest, making regime change or balkanization possible.”
Energy markets are the first port of call
Will
the relative resilience of markets last? Everyone is of course watching
the Strait of Hormuz, and more generally, oil prices. In these types of
crises, it’s the oil price that other asset classes take their cues
from.
Iran has threatened any vessel that passes through, while Trump has offered to insure said vessels “at a reasonable price”
with a US Navy escort to boot. Oil prices have drifted higher but the
movements have so far been disciplined – much more so than many
expected. A long disruption is not being priced in. It certainly helps
that the US is the largest crude producer in the world and (usually) the
third largest exporter. This means that any blockade chokes Asia and
Europe first, whereas America has a buffer – one, I might add, it didn’t
have in previous conflagrations.
Perhaps more worrying is the situation with natural gas. Europe’s
natural gas prices jumped by about 30% in the wake of an attack on
QatarEnergy LNG processing units. There is no easy solution here. Qatar
supplies 20% of the world’s LNG; if that supply disappears, an already
tight market will see prices explode. Norway’s energy minister has
already hinted that Europe might, tail between legs, come back to Russian energy.
War
is always disruptive, and when that war is in the Middle East, energy
markets come into sharp focus. We have seen this on many occasions. It
is indeed an acute pressure point for the US – and the world – and has
been for decades. Right now, markets are basically trading headline to
headline. But even in these head-swirling times, it pays to step back
from the noise and flashing headlines and look at things a little more
structurally.
The cost of financialization
One
of the defining features of fading hegemons is that they often harbor
fatal weaknesses that can be concealed for a long time. In the case of
the US, the erosion of industrial capacity and related financialization
of the economy may prove to be just that weakness. The former long ago
caused the US to become overly reliant on pricey, high-tech weapons at
the expense of the quantity needed for a protracted engagement – not to
mention the dependency on supply chains from China for the defense
industry.
Trump claims to have nearly “unlimited” ammunition stocks thanks to cutting Ukraine off. But many believe that if high-intensity strikes go on much longer, US stocks of certain critical missiles will start to run low. The US reportedly used
about five years’ worth of Tomahawk missile production in the first
three days of the war, and Patriot interceptors are known to be running
low. It seems to be a race as to whether Iranian missile launchers can
be destroyed faster than the American stockpile of interceptors
depletes.
But the financial side is no less important, even apart
from shock moves in oil prices. As the US economy de-industrialized, it
became increasingly financialized. This has many far-ranging
implications, but one of them is that a large portion of national income
is now tied to financial asset prices. A drop in asset prices thus
reverberates far and wide and triggers numerous knock-on effects. An
example of this is that even the US tax base is highly dependent on
asset prices.
The so-called ‘everything bubble’ of 2021 – when a wide range of
asset classes saw record valuations – led to a large increase in tax
receipts the following year (+21% year-on-year) when taxes on the income
generated on these gains came due. However, when the Fed hiked interest
rates in 2022, financial markets responded very negatively and asset
prices went down. Sure enough, the following year tax receipts declined,
and the federal deficit went sharply higher.
Notice the very
troubling negative feedback loop: higher interest rates suppress asset
prices, thus leading to a lower tax intake by the government, while also
entailing a higher debt-servicing expense. So a drop in asset prices
forces the government to spend more to service its debt while at that
exact moment decreasing the amount it collects in taxes. The result?
More Treasury issuance, of course, and at higher interest rates. The
moral of the story here is that longer-term the US cannot fiscally
survive a massive decrease in financial asset prices.
Also keep
in mind that roughly half of American households now have direct
exposure to equity markets through retirement accounts, mutual funds, or
brokerage holdings. In previous eras, the health of the stock market
was largely the concern of Wall Street. Today, it is entangled with the
security of the middle class.
This all might seem distant and
abstract in the midst of a war. Next year’s tax receipts or the state of
Americans’ 401(k) plans are the last thing on anybody’s mind in
Washington today. But these are real structural constraints that have to
be reckoned with. So far stock markets have only mildly drifted lower,
but with no panic selling. If the selling picks up, watch how quickly it
becomes a major headline.
The power of a simple yield
Even more sensitive than stocks
is the US Treasury (UST) market, which is the true plumbing of the
financial system. Higher UST yields tighten financial conditions
everywhere, all at once. In a heavily indebted and leveraged system such
as the US, rapid moves in this market are extremely dangerous. This is
where the constraints start to be measured in hours. A very telling –
albeit underreported – instance of this tremendous sensitivity to
Treasury market dysfunction came last year.
On April 2, Trump
introduced his so-called Liberation Day tariffs, slapping an
across-the-board 10% tariff on all imported foreign goods and larger “reciprocal tariffs” on the imports of dozens of countries that Trump claimed had “cheated” the US.
“This is one of the most important days, in my opinion, in American history,”
Trump proclaimed with his usual bluster in a speech on the White House
lawn announcing the measures. The world watched with a mix of
incredulousness, awe, and dread. It was a grand gesture, a reassertion
of US power.
Stock markets plunged immediately but Trump and his
team weren’t deterred. On Sunday evening, April 6, Trump talked tough,
saying “I don’t want anything to go down, but sometimes you have to take medicine to fix something.”
Alas,
the medicine would prove too bitter. At first, the big drop in stocks
pushed investors scurrying into bonds and UST yields proceeded to
actually fall (meaning prices rose) and reached 3.96% on Friday, April
4. So far, so good.
On Monday, however, UST yields engineered a
U-turn and started moving higher as the true implications of the radical
tariffs started to dawn. The following day saw more of the same. By
Tuesday afternoon, the 10y yield was approaching 4.30%. On Wednesday,
the very day the tariffs were supposed to take effect, the 10y added
another 10 basis points to 4.40%, putting the three-day gain at around
50 basis points.
Trump had seen enough. Or maybe he got a tap on the shoulder from
some big players who were soon facing margin calls. Regardless, like an
MMA fighter who taps out almost immediately after being put in a subtle
chokehold to the bewilderment of the crowd, it only took a couple of
days of disorderly market action for Trump to capitulate and cancel or
postpone most of the tariffs in what can only be called a humiliating
retreat. It was a telling moment for those who understood what had
happened.
Indeed, nothing makes regulators and politicians more
nervous than dysfunction in the UST market, which can get out of control
very quickly and suddenly cause markets to seize up. The US has shown
repeatedly that it will intervene forcefully at the mere sight of UST
market dysfunction. This is truly one of the Achilles’ heels of the US.
Where we are headed
There
has so far been no sign of disorderly UST activity, but that doesn’t
mean things are all clear. During times of chaos and uncertainty in the
world, the US usually sees an inflow of money seeking a safe haven.
Quite perversely, this happens even when the US is the cause of the
trouble. To some extent, this has held true now: the dollar rallied
sharply following the strikes on Iran.
Nevertheless, UST yields
have been creeping higher on fears of the inflationary effect of a more
protracted war. Investors are thus caught between the normal safe-haven
appeal of the dollar and fears of a surge in inflation that would hammer
USTs (i.e. drive yields higher, prices lower).
This movement hasn’t been sharp enough to garner much attention, but
the 10y is over the 4% mark as of this writing. Like old sailors who
by a sixth sense can feel trouble in the breeze, some analysts wonder if
something more disruptive might be brewing. Any definitive shift toward
the inflationary case – such as major disruptions in energy flows –
would likely push yields significantly higher. This would force the
administration into the crucible of risking a major financial crisis to
keep the war going.
The US has long benefitted from the
perception that it can blot out the sun with planes and missiles.
Deterrence, once credibly established, can be maintained with smoke and
mirrors – until, that is, somebody is willing to pay to see your cards.
Until now, nobody has really called Washington’s bluff, although the
Ukraine war has provided strong hints of this soft underbelly. Whether
this will be the conflict that lays bare the deep fundamental weakness
remains to be seen, but if markets start to think it is, things will
move very quickly.
The US and Israel are certainly acting with
impunity, and there no longer seem to be any institutional checks on the
ambitions of those prosecuting this war. But in a strange way, markets
could come to be a surrogate institutional check. A country that can’t
withstand a 50 basis-point move in its bond yields is by definition
restricted.
The precariously balanced edifice of American power
depends on a tenuous financial equilibrium existing within a highly
indebted and financialized economy. War is inherently destabilizing. The
longer this goes on, the more that equilibrium will be tested.
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