Ambrose Evans-Pritchard
The Iran war is doing more immediate damage to the economies of America, Europe and Japan via the bond markets than it is through the direct effects of the energy shock.
Borrowing costs have reached critical levels across the G7. They are resetting the price of credit for vast swaths of the global financial system. The effects are cascading through the mortgage industry and pushing a universe of over-indebted companies towards a refinancing crisis.
Stock markets cannot defy this force for long. Ultimately, equity prices are a highly geared function of future cash flows discounted by cost of interest. Sooner or later – and in my view sooner – the bond sell-off will short-circuit Wall Street’s tech boom and set off a major equity correction.
Trouble is almost unavoidable at this point because Donald Trump has no easy way of extricating himself from his calamitous misadventure in the Gulf.
We are still in the “phoney war” phase of the energy crisis but do not be fooled by that. “Oil markets are operating under a veneer of stability, but the underlying system remains acutely stressed,” said Michael Haigh and Ben Hoff from Societe Generale.
The International Energy Agency says 14.4 million barrels a day of prewar global supply has been cut off. Quick fixes have so far disguised the loss of one billion barrels, but the world is edging closer to the crunch point where depleted inventories hit the operational limits of the system.
Societe Generale says that even if the war ends today, the lagged effects will push Brent oil prices to $US125. “The sequence of tanker transit, discharge, refining and distribution implies a delay of at least 52 days, meaning end-users do not see relief until late July at best,” it said.
If the war goes on for another two weeks from now, the price would head to $US150 and the embedded loss of inventory would prolong the trouble into 2027. It will not take much for prices to go wildly higher.
The bond markets are “front-running” the implications. One neglected locus of danger is the $US11 trillion ($15.5 trillion) market for Japanese state and corporate debt.
Yields on 30-year government bonds spiralled to an historic high of 4.16 per cent this week after Japanese Prime Minister Sanae Takaichi added fuel to the inflationary fire with plans for yet another supplementary budget, this time to subsidise energy use.
“Yields are not yet flashing a red alert, but we think they are flashing an amber warning sign,” said Krishna Guha from Evercore ISI.
There are two opposite risks in the volcanic upheaval underway. One is that Japanese pension funds, life insurers and “Mrs Watanabe” suddenly start to repatriate a chunk of their $US5 trillion holdings of foreign debt securities to earn higher yield at home, reversing the giant “carry trade” that has boosted asset prices across the globe and enabled the private credit bubble.
The other risk is that Takaichi pushes her luck and precipitates a Truss-esque collapse of Japan’s fiscal credibility, but on a larger scale, spreading contagion through the global market for sovereign debt.
Deflation masked the country’s rising debt ratio for a quarter-century. The Bank of Japan was able to soak up debt issuance, cap rates with yield curve control and get away with it.
Trouble is almost unavoidable at this point because Donald Trump has no easy way of extricating himself from his calamitous misadventure in the Gulf.
This has become impossible with the return of inflation. Bond vigilantes are taking matters into their own hands, fearing that the Bank of Japan is dragging its feet and acting as the fiscal agent of the finance ministry.
“It is almost as if the administration welcomes inflation,” said Kawamura Sayuri, the chief economist at the Japan Research Institute. You can flatter the debt profile for a while by driving up nominal GDP growth, but that trick comes back to haunt.
Sayuri accused the government of playing with fire by shifting debt issuance to short-term bills and switching to inflation linkers, “an approach typically associated with countries approaching fiscal distress. It risks tightening the noose around the government’s own neck,” she said.
This is a treacherous moment for Japan. Data from the Bank for International Settlements shows that Japan’s combined public and private debt ratio is the highest of any major country at 357 per cent of GDP. France is a close second at 325 per cent, above the US at 250 per cent, Italy at 232 per cent, Britain at 219 per cent and Germany at 197 per cent.
The Iran war has pushed 10-year bond yields in France and Italy to almost 4 per cent, crossing the danger line where interest costs rise faster than the trend growth rate of nominal GDP. This is how a vicious budgetary circle begins.
Gilles Moec, the chief economist at AXA, said an energy bailout or cost of living rescue in either country would “immediately worsen debt dynamics”.
Italy’s public debt ratio is already climbing and will jump from 137.1 per cent of GDP last year to 138.6 per cent this year on the government’s own forecast.
It beggars belief that the UK Labour Party should precipitate an unnecessary leadership crisis with this degree of peril in the world bond markets.
The Streeting-Burnham pranks have pushed British 10-year yields far above 5 per cent, further destabilising the country’s fragile fiscal accounts and doing gratuitous damage to Britain’s global reputation. As a citizen, I am outraged.
The world’s financial system is now hostage to Trump’s mood swings. The outcome will be determined by how much political pain he is willing to endure and whether he can suppress his pathological need for escalation dominance.
Yields on 30-year US treasuries have spiked to 5.15 per cent, higher than the Biden peak after Covid. This implies that Fannie Mae’s rate for 30-year mortgages will rise towards 7 per cent, given the historical spread of 180 basis points over benchmark treasuries.
Wholesale inflation in the US jumped to 6 per cent in April. Lagging consumer inflation has hit a three-year high of 3.8 per cent, and will be stuck at unpleasant levels as the spike in fertiliser, metal, plastics and transport prices feeds through into a K-shaped economy where the bottom half now faces falling real wages.
Equity markets are still betting that Trump will declare victory in Iran and walk away before his MAGA base frays further and his poll rating drops to levels that threaten Republican control of both houses of Congress.
No such easy option exists. Iran is winning the war by surviving. US intelligence estimates that 70 per cent of its missiles are still intact and 90 per cent of its launch sites around the Strait of Hormuz are still functional.
The US has been burning through its Patriot interceptors at a faster rate than it has been able to degrade Iran’s drone strike capability. Iran’s nuclear stockpile has scarcely been touched.
The war has been a disaster on every level.
The assassination of Ayatollah Ali Khamenei has removed a leader who issued a fatwa against nuclear weapons and opposed blockading the Strait of Hormuz, replacing him with a tight-knit regime of military hardliners in the Revolutionary Guard that has no such compunctions and which has discovered the enormous strategic value of closing the Gulf. The war has been a disaster on every level.
There are only two viable paths for Trump: either he goes a long way to meet Iran’s core demands, on worse terms than were available before the conflict, with reparations, an unfreezing of assets, a de facto shipping toll through the Strait of Hormuz and a face-saving nuclear fudge; or he escalates to a full-blown land war that risks destroying his presidency.
“Trump faces a fundamental strategic decision. He cannot simultaneously frame Iran as a regime to be destroyed while also expecting meaningful negotiations to succeed,” said Danny Citrinowicz, the former head of the Iran desk of Israel’s military intelligence.
Since Trump cannot make up his mind to do either, there must be a very high probability that Tehran will string him along until the pain in Washington becomes excruciating.
Ultimately this will cause a global downturn and core sovereign bond yields will fall again as equities return to earth and markets radically reprice the macro-universe. But first it is going to be a long, tense northern summer.
Telegraph, London
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