INFLATIONARY CONSEQUENCES OF THE WAR / MACLEOD FINANCE

Inflationary consequences of the war

Financial markets face a crisis. The virtual cessation of Middle Eastern energy supplies will have very serious consequences for global inflation, bond yields, and the dollar itself.

ALASDAIR MACLEOD

Introduction

Like rabbits caught in the headlights of an oncoming car, investors barely moved in the face of last week’s events in Islamic lands. 

With the oil price moving sharply higher on Friday, there is bound to be a dawning realisation in the coming weeks that there’s an inflation shock coming. 

It is not yet seen to be serious, because there’s an assumption that the combined US—Israeli attack on Iran will be over in a week of two with Iran’s defeat and that normality will return.

This is a mistake which underestimates Iran, pandering to western propaganda which is one sided. 

It ignores the fact that both the US and Israel are short on ordnance and missiles, while in fear of the Great Satan Iran has been growing and evolving its arsenal for the last forty years.

Whatever the outcome, US involvement appears to be the height of hubristic folly. 

Short of a nuclear detonation, Hormuz will be closed for an extended period. 

Iran is also spreading its counterattacks not just to US bases in the region, but to energy infrastructure in the Gulf and also Azerbaijan whose Baku pipeline is a major supplier to Israel. 

Not yet in the headlines, the Houthis in Yemen are likely to seal off the Red Sea and Suez as well.

Aware of the dangers of further escalation, GCC member states are reported to be desperately seeking an early end to the conflict. 

In addition to loss of oil and LNG revenues, they know that the blockade of inbound container ships through Hormuz will create enormous economic damage for them, with essential supplies including food rapidly running short. 

And they will be praying that Iran doesn’t attack water desalination plants upon which the region relies heavily.

Doubtless, in a few years’ time volumes will be written about the consequences of all this folly. 

But the purpose of this article is to concentrate on just one aspect: the shock to the western financial system. 

And we should note that following the Covid shock inflation began rising almost immediately, as the BLS chart of US CPI change below demonstrates:

It rose from 0.1% in May 2020 to 9.1% in June 2022. 

The sharp rise, which was unexpected by financial analysts at the time, forced interest rates higher as central banks complied with their inflation mandate and bond yields rose sharply higher as well. 

The oil price had already risen from its low in April 2020, finally peaking at $115 in May 2020.

In February 2022, Russia commenced her Special Military Operation against Ukraine, which led to Russian oil and gas being sanctioned, though in practice flows into Europe and elsewhere didn’t cease. 

By then, oil had already risen to $90. 

The point being made here is that inflation and US bond yields rose at the same time as the oil price. 

The consequences for bond yields are illustrated below:

 The question arising is what happens to inflation and bond yields in 2026, assuming no quick resolution to the Iranian conflict and that Hormuz remains effectively closed? 

We can then expect far higher oil prices with second order effects on petrochemicals, fertilizers, and other chemical derivatives. 

In 2020—2022 they brought forward the inflationary consequences of Covid’s currency debasement, along with a sharp rise in bond yields: they could do so again.

If oil prices head much higher, there are bound to be similar effects to the post-covid experience in the coming months. 

Not only will the yield on the 10-year UST note break higher, but in all likelihood significantly so. 

It will bring forward the debt-cum credit crisis that was already brewing, crashing equities and the economy as overleveraged businesses fail. 

Already, there’s a run developing on leveraged private equity reflected in mutual funds such as Blackrock’s illustrating the fragility of the credit system at current interest rates, let alone higher ones.

Already, equity markets are more overvalued relative to bond yields than in the last 40 years, and probably for ever. 

This is shown in our last chart:

Further increases in the long bond yield will crash the extremely overvalued equity market as well as undermining the very existence of the financial system.

The Fed and US Treasury will have a choice: expand QE without limit in an attempt to rescue everyone and support the equity market or just stand back and let nature take its course. 

Either the dollar ‘s purchasing power collapses or everyone else does, and then the dollar does anyway.

That’s why central banks are selling paper currencies for gold. 

And why China has told its banks to sell their US treasury bonds.