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Will financial markets crack before the Strait of Hormuz is reopened?
As we lurch into the fourth week of the Iranian conflict, we reflect on the situation, focusing on the response of financial markets. Importantly, what are market movements telling us about the expected duration of the closure of the Strait of Hormuz?
Oil and gas markets have responded swiftly to the conflict, with the WTI crude May 2026 futures lifting from US$60/bbl to around US$95/bbl, where it has remained for the last week. Similarly, European and Asian natural gas prices surged by around 60%, where they remained until yesterday’s strike by Israel on the Iranian South Pars gas field and Iran’s retaliatory strike on the world’s largest LNG plant in Qatar that saw gas prices double compared to the beginning of the conflict.
Given the surge in oil and gas prices, it could be expected that investors’ expectations on the future path of inflation would have reacted sharply. In the short term, this is definitely the case. The average rate of US inflation expected over the coming 12 months has jumped to 5.2% since the outbreak of war.
However, the lift to inflation is expected to be short lived, with inflation expected to average 3.3% over the next two years, implying a swift fall in inflation following a temporary war-induced spike.
Consistent with the muted response to the expected duration of the inflation shock, central bank policy responses have been measured. This week, in a 5 to 4 split vote, the RBA raised the Australian cash rate by 25 basis points (bps), while the US Federal Reserve (Fed) kept rates on hold, but indicated they were still on track to ease rates by September. Current futures markets have fully priced two more rate hikes by the RBA, with a 75% chance of a further rate hike by November. Compared to what was expected prior to the conflict, the market has priced in two more rate hikes by the RBA.
In the US, the market had been factoring two rate cuts by the Fed prior to conflict, while now the market expectation is that they will remain on hold, notwithstanding the Fed’s signalling of a potential September rate cut. With inflation expectations remaining well anchored and with calm and measured monetary policy responses, it is unsurprising that government debt markets have also experienced subdued rate rises, given the circumstances. Most of the action has been at the short end of the yield curve, reflecting the repricing of monetary policy over 2026 and into 2027.
In the US and Australia, 2-year government bond yields are up by around 50bps (reflecting the elimination of two expected rate cuts by the Fed, and two additional rate hikes by the RBA). But as we look out along yield curve, the rise in yields is smaller, with 10-year US Treasury yields and 10-year Australian Government Bond yields each up around 35bps. Equity price movements are arguably somewhat more nuanced than in bond markets. In US markets, the reaction to the conflict is relatively muted, especially considering the fully priced nature of their market leading into the conflict.
The US market is off just 4% (as measured by the S&P 500) since the start of the war. In contrast, the Australian market is down by around 8% (as measured by the ASX S&P 200). The difference between the performance of the S&P500 and the ASX is also indicative of sentiment towards the conflict. The S&P 500 is being anchored by its largest component - the tech sector - which accounts for around 71% of the index. Surprisingly, given the full pricing of most tech stocks, this sector has held up well, down just 4% since the start of the conflict.
In contrast, the tech component of the ASX is tiny, accounting for just 0.15% of the index, while the materials subcomponent accounts for about a quarter of the ASX (and only 2% for the S&P 500). The materials sector, which is heavily weighted to gold, copper and nickel producers as well as large-scale iron ore producers BHP, Rio Tinto and Fortescue, is down by 20%. In particular, gold stocks are down heavily, between 30% and 40%. Counterintuitively, the price of gold has fallen by 11% since the start of the war (silver is also down by 23%). Why should the price of gold fall as geopolitical risks rise?
Gold production is energy intensive (as is iron ore, nickel and copper) and is therefore caught in a cost squeeze as energy prices rise. The negative impact is more than offsetting the swing to gold as a safe-haven asset, again re-affirming our conjecture that the market response to the conflict is muted. Where do we go from here? In our Brief of two weeks ago (Will the Iran conflict undo Goldilocks?), we reported our scenario analysis and highlighted the muted financial market response in our Benign scenario, where investors and central banks expected the conflict to be short term in nature.
In that scenario (in which the Strait of Hormuz reopened at the end of/start of the June/September quarter), Australian inflation spiked to 5%, but retraced over the second half of the year. The RBA lifted the cash rate to 4.35%, before lowering rates back to 4.1% towards the end of the year. This contained the fallout on consumer spending, with households able to use built up savings to cushion the temporary rise in the cost of living. A similar narrative plays out in the US and other major economies. So far, markets appear to be holding onto this view.
As the Trump Administration becomes bogged down in the war, pressure is mounting on the US to find an exit from the conflict. With support waning from both the Republican party and within the MAGA movement itself, the Trump Administration will likely be forced to negotiate a reopening of the Strait of Hormuz with Iran sooner rather than later.