The goals presumably remained the same, but the modus operandi is changing. Military adventures have not borne fruit, but economic warfare could result in the reopening of the Strait of Hormuz, or so the thinking in the US Administration goes. Its President announced crushing sanctions against Iran (without elaborating) and warned allies and foes alike of the consequences for any country that supports the Persian Gulf nation. It is an implicit admission of the failure of the military operation that was meant, first, to remove the regime and deprive it of its nuclear capabilities, and later simply to ensure that oil would start flowing through the Strait.

Is there a difference between armed conflict and economic warfare? The market does not think so, as crude oil rallied nearly $2 on the news. After all, it will not rob Iran of the possibility of retaliating, keeping Hormuz shut, and targeting regional energy infrastructure and shipping. All the while, the clock to the US midterm elections is ominously ticking. The outlook for the Republican Party, with retail gasoline and diesel prices considerably above $4/gallon and $5/gallon, respectively, is grim as voters’ frustration grows. Brace yourself for more impromptu and erratic twists and turns in this Middle Eastern tragicomedy, with unforeseeable reverberations.

Economic Prospects are Turning Bleak

You take global or regional oil consumption estimates and deduct supply forecasts from them. If the result is negative, you are likely to bet on higher prices. If it is positive, you form the opposite view. Both demand and supply/production/exports react sensitively to whatever is thrown into the equation, be it economic developments, wars or Acts of God. Currently, and for the last six months, Middle Eastern supply considerations have been the main course, seasoned with the rambunctious hostility surrounding Russia and Ukraine. Although oil prices drifted lower after their instinctive reaction to the US/Israeli blitz on Iran back in March, they understandably refuse to plummet as the most pivotal artery of oil transport remains closed.

Yet it is a macroeconomic axiom that the two most significant factors in the formation of oil prices interact with and mutually affect one another. To use the oft-cited cliché, the best cure for high oil prices is high oil prices, and vice versa. This is particularly true in the third decade of the 21st century, when oil intensity is declining, along with its inelasticity. Currently, supply-side developments are viewed as the more dominant factor, but demand will inevitably be impacted at some point in the form of economic headwinds. It invariably is.

There is both a chronic and an acute angle to this approach. The long-term factor is government debt. A timely reminder arrived on Wednesday. Government debt piles, while manageable for the time being, will unavoidably hinder growth prospects. A series of financial meltdowns, health crises and wars has led to a continuous increase in government borrowing. US national debt crossed the $40 trillion threshold on Tuesday, while global public debt is now above $100 trillion ($100,000,000,000,000) and is expected to exceed 100% of global GDP by 2029, the IMF prognosticates. While the fiscal cliff is visible, it is still afar off. Yet managing these debts will become progressively more onerous. The US government now routinely borrows just to pay the interest on its existing national debt. Investors will demand higher returns on their lending to governments; therefore, bond yields and interest rates will rise, impeding economic growth and prosperity.

The more pressing issue is sticky inflation, precipitated by the Iranian conflict, which, frankly, and in hindsight, appears to be political suicide for the Republican Party and the Israeli Prime Minister ahead of elections in both countries. Headline figures are directly, and core readings indirectly, affected by costly energy. The central banks of major economies all have a 2% target, considered to be the equilibrium level that is neither excessive nor restrictive. These targets, chiefly thanks to the Iranian conflict, are slipping away, or at least falling into the category of daydreaming. Annual consumer prices increased 3.4% in the US, 3% in Canada, 2.9% in the UK and Italy, 2.8% in Germany, and 2.4% in France in July.

Resilient and prolonged upside bias on consumer prices is faithfully reflected in bond yields, which hold a mirror to inflation expectations. In fact, such is the anxiety level that this week the US 30-year Treasury bond yield ascended to 5.34%, also pressured by AI spending, scaling 19-year highs. This forced the US Treasury to intervene and announce that it would double its long-dated debt purchases, which managed to instil a sense of calm in the bond market.

It was a welcome but brief relief. Yields rose again yesterday, proving that mitigating US or global inflation will take more than one public institution lending money to another. And the repercussions for oil prices? The relationship between energy prices and consumer prices is an intriguing one. The rule of thumb is that they are positively correlated, at least in the long run. This statement rings true for the current situation, as there has been no love lost between the CME Heating Oil contract, the bellwether of the recent move higher, and the 30-year bond yield – they have been correlated almost 90% of the time over the last two months.

And it makes perfect sense. Expensive energy drives inflation and inflation expectations, thereby pushing bond yields higher. Better yet, when inflation expectations are on the rise, energy is used as a hedge against inflation, exacerbating the phenomenon. This relationship, however, will not be sustainable; something will have to give. Most plausibly, it will be interest rates. Central banks are currently sitting on the fence regarding rate hikes. It is a painful inertia, but it can last only for so long. Whatever the US President’s heart desires (lower interest rates) in the event of prolonged inflationary pressure, rates must go up. This will dampen expectations of economic growth, adversely impacting oil demand growth. This is when the current relationship between oil and bond yields will break down; this is when the honeymoon is over, and this is when the direct relationship between oil and yields will shift to one between oil and equities.

Overnight Pricing