THE EXPECTATIONS GAP / MACLEOD FINANCE

 The expectations gap

Central banks are hiding the truth about the economic and financial consequences of the crisis in the Persian Gulf. Markets are badly misled and discovery will be explosive.

ALASDAIR MACLEOD

Summary

In this article I explain the market consequences of America and its allies hiding the truth of its failure in the Persian Gulf war from markets. 

So successful has the propaganda been that markets are now more mispriced than I can remember in the 56 years of following them. 

Yet investors are blissfully unaware of the acute dangers to their wealth.

The extent of the US’s propaganda campaign even fooled central bankers and government treasury ministries. 

But the closure of the Red Sea at the Bab el-Mandab and the potential loss of a further 7 million barrels per day from global oil supplies is a wake-up call for policymakers. 

There are signs that they are now very worried about the prospects for consumer prices, the global economic outlook, government finances, bond yields, and financial markets generally.

But of course, they are not telling us for fear of spooking markets.

Introduction

The inflationary consequences of the closure of Hormuz and now Bab el-Mandab are beginning to undermine policymakers’ expectations. 

It seems that the Houthi’s attacks on Saudi refining have removed up to 7 million bpd and their derivatives from global supply, which will have dashed lingering hopes that the consequences of the war on Iran can be contained. 

And from his actions it is clear that President Trump is cornered into falsely claiming time and again that the Iranians want peace when they do not, to conceal the true seriousness of the crisis from financial markets.

None of government insiders’ assessments and concerns are made public. 

But central banks and finance ministries in the G7 communicate with each other continually. 

They will have some grasp of the current situation, know that there is no resolution in sight, and are reassessing the consequences.

In Europe, which is home to four of the G7, there is the additional problem of drought which is more than halving crop yields. 

For lack of grazing, farmers are forced to feed their livestock with hay and silage stored for next winter. 

Furthermore, it is reported that Russia has closed Ukraine’s shipping access to the Black Sea, which effectively stops her cereal exports. 

Before the war, Ukraine was routinely referred to as the breadbasket of Europe and the impact couldn’t come at a worse time.

Therefore, food prices across the board are set to rise significantly, which combined with the consequences of the Hormuz and Bab el-Mandab closures for diesel, petrol, aviation fuel, and shipping bunkers ensures that consumer prices will rise sharply by winter. 

Evidence that this is now feared in the UK’s Treasury was confirmed by the new Chancellor, John Healey threatening supermarkets not to “price gouge”. 

There was no necessity for his statement, which was almost certainly triggered by internal Treasury briefings.

Collectively, the investing public seem blissfully unaware of the true situation, nor are they being told. 

The Bank of England held its base rate at 3.75% this week but stated that “a further escalation of the Gulf war could drive inflation above 4% next year”. 

This should be interpreted as the Bank knowing that it will be worse than they admit but are being careful not to alarm financial markets.

In the US, surveys show that consumers are not taking an inflation risk seriously. 

According to University of Michigan Surveys of Consumers, year-ahead inflation expectations fell to 4.2% in the final July 2026 reading (from 4.6% in June). 

Five-year expectations held steady at 3.3%. 

The New York Fed Survey of Consumer Expectations one-year-ahead were 3.7% in June, the highest since September 2023. 

Three-year expectations rose to 3.3% and five-year stayed at 3.0%. 

Keep calm and carry on is the message.

As it becomes apparent to sleeping summer markets that the Middle East situation is not going to be resolved soon, there will be a realisation that current estimates of inflation are unrealistic. 

That this knowledge is broadly unofficial for now is consistent with government bond yields not yet breaking higher convincingly. 

But as higher inflation becomes more expected, we will see bond yields rise above their three-year consolidation. 

The current situation is shown in the chart below.

Just as there was a rapid readjustment of yield following the covid shock, we can expect a sudden realisation of the seriousness of the Hormuz and Bab el-Mandab crisis to shock bonds into significantly higher yields. 

This is the consequence of the inflation expectations gap being closed as it trickles down from central bank insiders to major foreign holders, domestic bond investors, and finally the general public.

This emerging crisis is against a background of stretched US government financing. 

Total debt is $40 trillion, of which major foreign holders own $9.37 trillion. 

About half ($4.91 trillion) is held by Japan, China and other holders who are probably not carry trade investors. 

The question arises as to what level of bond yield will be required for them to add to their investments and not to sell their existing holdings.

These investors will assess the US’s creditworthiness. 

They see declining revenues as the economic consequences of the closures of Hormuz and Bab el-Mandab and accelerating US government debt as a consequence of:

· existing budget deficits,

· an increase in deficits due to declining revenue and increasing welfare costs, and

· the increase in borrowings to reflect economic stimulation to prevent the US economy and financial markets from deteriorating further.

This is before foreign holders of dollars consider their own national priorities. 

Almost certainly, the US and other G7 nations are in debt traps: interest rates should be higher to reflect the severity of debt traps, but higher interest rates worsen the situation. 

Higher interest rates beget still higher interest rates. 

It is a situation which leads to repatriation of investment capital.

Already, government interest costs (not that they are ever paid without incurring further borrowing) are at runaway record levels.

The following chart is of the US Government’s interest payments:

Personal interest payments in the US’s private sector are also at record levels:

In a debt trap there is no discernible limit to how high bond yields will go. 

Assuming that the US Government does not radically cut its spending, not only will the scale of government borrowing accelerate but the Fed will have no option but to suppress interest rates to facilitate affordable financing. 

It will be despite soaring consumer prices.

Consequently, with interest rate suppression the dollar will be sold down by foreign holders, who have an exposure of $48 trillion in bonds, equities, and bank deposits according to US Treasury TIC figures. 

This is broken down by category in the table below.

G7 governments are in similar government debt positions to the US, but with less foreign creditors. 

Nevertheless, the mechanics of debt traps apply to them all. 

And as we have seen recently in Japan, the Finance Ministry has prompted pension funds to buy Japanese debt which can only be done by selling foreign debt. 

It was this threat which caused the US Treasury to support the yen by selling euros in an attempt to relieve Japanese selling pressure on US Treasuries.

Again, behind the scenes we can sense a degree of panic developing in the G7’s corridors of power. 

It will cause a severe volte-face in markets as the panic spreads. 

It usually starts with investors selling assets and currencies foreign to them. 

This selling spreads from bonds to equities, which are already excessively valued relative to current long bond yields, a bubble set to implode when bond yields go higher. 

Note that foreign investors hold $24.5 trillion’s worth of US equities. 

The popping of that bubble will have them scurrying for the exit, while at the same time US banks are forced to sell equities held as loan collateral.

The impact of all this on the dollar is likely to be sharp and sudden, everything conspiring to drive its value down. 

Currencies are a commodity like everything else and when there are few buyers and many sellers that is enough to drive them lower. 

A value crisis for the dollar might give a temporary boost to other G7 currencies on a flow of funds basis, but their credibility is equally fragile.

The stand-out beneficiary is gold, which is and always has been legal money without counterparty risk. 

And that is now beginning to rise priced in fiat dollars along with its close cousin silver. 

Don’t rely on charts as everyone seems to today. 

Just understand the mortal threat faced by G7 governments whose finances are running into a brick wall. 

The eventual failure of every fiat currency in history has been the product of unsustainable government finances and that is the point now reached.