Cargo ships in the Gulf, near the Strait of Hormuz, as seen from northern Ras al-Khaimah, UAE, in March.Stringer/Reuters
John Rapley is a contributing columnist for The Globe and Mail. He is an author and academic whose books include Why Empires Fall and Twilight of the Money Gods.
On Wednesday, after news broke of a two-week pause in the Mideast war, stock markets surged and the price of oil plunged. On the face of it, peace had broken out and normal activity could resume.
But the day’s developments, and events over the rest of the week, revealed just how dangerous this moment continues to be. The risks of a catastrophe remain.
Two noteworthy things about the initial ceasefire agreement stood out. One is that it appeared U.S. President Donald Trump caved. The Iranians rejected his proposal and came back with their own, which he accepted as a basis for negotiations. Although this always seemed the most likely outcome, it is still a remarkable setback for the United States’ position in the world, should it stand.
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The second thing, though, was that the ceasefire was shaky from the start. It may well not stand. The two sides are so far apart that it’s hard to believe they can reach any kind of permanent agreement. Almost immediately the White House began contradicting the Iranian claims as to what was in the deal and the Israelis insisted their war in Lebanon wasn’t included – a point of confusion in the initial drafts.
But the biggest flaw in the ceasefire is the hostage it leaves to fortune – or more specifically to Iran: With the Islamic Republic still controlling the Strait of Hormuz, shipping through the channel remains largely frozen. So while the oil price fell on Wednesday, it was still more than 50 per cent higher than when the war started. On Thursday it resumed its upward climb.
Meanwhile, beyond the immediate euphoria, markets are showing signs of strain. In particular, the interest rates on Western government bonds surged during the war and didn’t come all the way back down with the ceasefire. Most concerning of all is the U.S. Treasury bond. Its interest rate has settled in a range well above where it started the year and, unlike other government bonds, didn’t rally strongly on Wednesday.
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It may seem that the higher yields on loans to governments merely reflect concerns about rising inflation. However, inflation expectations haven’t really changed: Most bond traders assume there will be a short-term shock, but that over the long term it will return to about where it has been recently. Instead, it appears the so-called term premium on government debt, and especially U.S. government debt, has gone up.
This reflects growing worries that the United States’ fiscal position is becoming unsustainable. With the Trump administration having already raised the debt to dole out tax cuts, it’s now asking for a huge increase in the defence budget. It looks as if Washington intends to borrow from here to eternity. A recent paper by the U.S. National Bureau of Economic Research finds that amid this profligacy, U.S. Treasury paper is losing its appeal. Further worsening matters is that the supply of petrodollars, or surpluses on oil sales by Gulf states that are parked in U.S. Treasury paper, has dried up as a result of the conflict.
Given that the U.S. has by far the world’s biggest bond market, what goes on there doesn’t stay there: When U.S. rates rise, they drag up the rates other governments must pay. Besides, while the problem of fiscal incontinence is most serious in the U.S., it is common to many Western countries. The European Union recently warned governments not to turn an energy crisis into a fiscal one by providing excessive support packages to the citizenry, as was done during the COVID-19 pandemic.
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The rise in interest rates since the war began reveals how dangerous the moment has become. Were the war to resume and recessions to break out, Western governments would have much less fiscal firepower than in the past to fight them. Meanwhile Western central banks, after decades of underwriting cheap government credit, are reluctant to cut rates as inflation worsens. And although the current rise in inflation has been driven by a supply shock, recent research by the U.S. Federal Reserve suggests that the economic landscape may differ from what existed prepandemic, producing more stubborn upward pressure on inflation.
Taken all together, these factors make it likely that interest rates will settle at a higher plateau than before the war. This, in turn, could affect the broader investment landscape, knocking down the value of stocks and real estate. Even if peace returns, there may be a long slump in markets. If fighting resumes, the market shock could be severe.
Restoring peace is thus not only a moral imperative, it’s an economic one too. Without it, we’ll all pay a high price.