Further escalation in Iranian-Israeli tensions could push oil prices above $80, which would mean further gains for the U.S. dollar. The Federal Reserve was already likely to keep rates steady until the third quarter, and recent developments reinforce this view.
This is what happened
Israel has launched simultaneous strikes on key Iranian nuclear facilities and Iranian ballistic missile sites, in addition to targeting senior Iranian Revolutionary Guard commanders and nuclear scientists. In response, Iran retaliated by launching nearly 100 drones aimed at Israeli territory in a significant escalation of regional hostilities. Israel has declared a state of emergency, describing the strikes as preemptive and warning of further operations.
Although the United States was not directly involved, Iran accused Washington of complicity and may target American assets in the region. Previously, the U.S. had restricted Israeli actions amid ongoing nuclear negotiations, but these talks now seem to be stalled.
Similarly, maritime security risks have escalated in the Strait of Hormuz, the Arabian Gulf, and the surrounding waters, representing critical choke points for global oil and liquefied natural gas trade. Although energy infrastructure has not yet been targeted, the threat of future strikes could disrupt supply chains and push prices higher. Any restrictions on maritime trade could also have long-term effects if Tehran decides that a blockade is an effective retaliatory measure that avoids direct targeting of regional American assets.
Meanwhile, the recent blame directed at Iran by the International Atomic Energy Agency has increased Tehran's diplomatic isolation. Iran now faces a pivotal choice: either seek a nuclear breakthrough, with the potential of acquiring a nuclear weapon within months, or return to negotiations under the weight of severe economic sanctions. A nuclear breakthrough would significantly alter the regional balance and would almost certainly provoke U.S. military intervention.
With the possibility of further potential Israeli strikes, it is unlikely that the Iranian drone attack will be Tehran's final response. This means that Tehran will have to balance the need to reassert deterrence, considering its depleted network of proxies, against the risk of provoking a wider war and direct U.S. intervention. While past behavior suggests that Iran may ultimately de-escalate to maintain regime stability, the situation remains extremely volatile.
Impact on energy markets and potential escalation scenarios
The high level of geopolitical uncertainty requires energy markets to price in a significant risk premium due to the potential for supply disruptions. Initially, strikes on Iran led to a 13% rise in oil prices, although markets have since given back some of those gains. In the absence of any actual disruption in Iranian oil flows, we believe that the spike will continue to fade.
However, the market will need to price in a larger risk premium than before the attacks, at least in the short term, meaning that Brent crude will trade in a range of $65-70.
Thus, any escalation that disrupts Iranian oil flows will further support prices. Iran produces about 3.3 million barrels of crude oil daily and exports around 1.7 million barrels per day. The loss of these export supplies would eliminate the surplus expected in the last quarter of this year and drive prices toward $80 per barrel.
However, we believe that prices will eventually stabilize in the range of $75-80 per barrel. OPEC controls 5 million barrels per day of excess production capacity, so any disruption in supplies could prompt OPEC to bring this surplus back to the market faster than expected.
The most severe scenario is if escalation leads to disruption of shipping through the Strait of Hormuz. This could affect oil flows from the Arabian Gulf. Almost a third of global seaborne oil trade passes through this strait. A significant disruption in these flows could be enough to push prices to $120 per barrel.
OPEC's spare capacity will not help the market in this case, as most of it is in the Arabian Gulf. Under this scenario, we will need to see governments draw on their strategic oil reserves, although this will only be a temporary solution. Therefore, much higher prices are needed to ensure demand destruction.
This escalation also has implications for the European gas market. However, to see gas prices rise significantly, we will need to see the worst-case scenario of disruptions in the Strait of Hormuz. Qatar is the third-largest exporter of liquefied natural gas, accounting for about 20% of global trade.
All these supplies must pass through the strait. The global liquefied natural gas market is currently balanced, but any disruptions will push it into deficit and increase competition between Asian and European buyers.
The economic impact and what it means for central banks
The sharp rise in oil prices threatens to disrupt the current narrative surrounding inflation in the United States, which has proven to be more moderate than expected in the face of U.S. tariffs. So far, inflation in goods has remained notably subdued, while price pressures in the services sector, which makes up three-quarters of the core Consumer Price Index basket, have begun to ease.
We do not believe this will last. Reserve inventories may have allowed companies to delay pricing decisions, but this will not continue for much longer. We expect to see larger increases in monthly inflation figures during the summer. The recent Beige Book from the Federal Reserve indicated widespread reports of stronger price increases in three months. This is compounded by rising oil prices.
Ten years ago, central banks, including the Federal Reserve, viewed rising oil prices as a benign factor for interest rates. Weaker growth typically outweighed concerns about short-term inflation spikes. However, this thinking has changed significantly since the COVID pandemic.
In Europe, the rise in natural gas and oil prices in 2022 led to a prolonged increase in inflation in the services sector. Officials from both the Federal Reserve and the Bank of England have warned of a feedback loop emerging today. The Bank for International Settlements has cautioned central banks that it will be difficult to ignore supply shocks.
These concerns may be exaggerated. During both the pandemic and the energy price shock of 2022, the broader economic environment was primed for inflation to take off. In both cases, governments provided significant financial support to offset the impact, a task that has become much harder today due to rising interest rates and tense financial markets.
The job market has also been much stronger. In 2022, there were two job openings for every American worker. Now there is only one job opening, which is below pre-pandemic levels. The scope for a recovery in wage growth is more limited.
It is clear that rising oil prices reduce the chances of the Federal Reserve cutting interest rates in the third quarter. We have already felt a pullback in these chances over the past few weeks. However, by the latter stages of the year, we believe that the impact of tariffs on inflation will start to wane and inflation in the services sector will begin to decline.
Meanwhile, the economic blow from the U.S.-China trade war will become more apparent in areas like unemployment. We expect the first rate cut from the Federal Reserve in the fourth quarter, likely starting with a 50 basis point cut in December. A rapid series of cuts could bring rates down to 3.25% by mid-2026.
These developments also complicate matters for the European Central Bank. Inflation in the euro area has been subdued in recent months due to falling energy prices. However, that may now change, and rising costs present another concern for the manufacturing sector.
This is another blow to confidence, already shaken by the broader geopolitical and economic uncertainty. Consumers are saving more, and companies are delaying investment. Further escalation of tensions in the Middle East could heighten these negative sentiments and impact growth.
If this occurs over an extended period, the euro area outlook will become more stagflationary. The ECB's scenario shows that a 20% rise in energy prices could reduce growth by 0.1 percentage points in both 2026 and 2027. Inflation would be 0.6 and 0.4 percentage points higher, respectively, compared to the baseline.
While we have not yet reached this extreme scenario, it makes it difficult for the European Central Bank to respond. Rising energy price volatility means the ECB will look more closely at core inflation. We expect another rate cut from the ECB in September, although President Christine Lagarde will be pleased that she will benefit from the recently announced temporary pause to see how things unfold before deciding whether to cut rates below the neutral level.
Impact on foreign currencies
The dollar bounced back amid Israeli-Iranian developments overnight, but it is still far from recovering losses incurred earlier this week. We believe that the impact on equities (declining U.S. stock futures) is hindering dollar gains, as the sensitivity of the American currency has shifted toward risk sentiment.
Should tensions escalate and turn into a broader conflict with rising oil prices, there should be more room for a stronger dollar, which is already in oversold territory and undervalued in the near term. However, the relatively contained rise in the dollar this morning is further evidence that it has lost some of its safe-haven status, and there remains a persistent structural downward bias.
This is entirely attributed to internal factors in the United States, so we suspect that any external event (such as geopolitical tensions) will not remedy the damage done to the dollar. We anticipate active buying when the euro/USD dips at any sign of de-escalation. In our view, the Japanese yen remains the most attractive hedge currency.
Impact on market prices
Markets have already reacted on Thursday to escalating tensions around Iran, as German government bonds reaffirmed their status as a safe haven, starting to outperform bond swaps. Following the actual news of military strikes on Iran, the market's initial uncalculated reaction of a flight to safety quickly faded and gave way to concerns regarding monetary policy implications – as the flattening of the yield curve indicates concerns about stagflation, as well as rising short-term inflation swaps.
However, in the broader context, the market's reaction to interest rates is likely to remain muted. Tariff policies and financial concerns in the U.S. and spending outlook in the EU have already created a highly uncertain environment – and escalation in Iran only adds to the noise. Markets are still looking for another cut from the ECB to 1.75%, although they have begun to scale back expectations for the ECB to move beyond that. In longer rates, the 10-year swap rate has risen somewhat above 2.5% again, but it remains within recent ranges.
Impact on credit markets
Recently, credit markets have absorbed and ignored all concerning external factors. Abundant liquidity has led to a significant decrease in supply, while price spreads have narrowed considerably at the same time, often reaching their tightest levels this year. Therefore, the impact on credit spreads should be subdued for now as these strong technical factors continue to drive spreads while external factors are ignored. The initial reaction of spreads is a slight widening of margins, but if these geopolitical tensions do not escalate, the credit market could quickly return to its narrow trend.
However, a state of uncertainty dominates the long-term outlook for corporate balance sheets, as rising commodity prices and inflation affect profit margins – another negative for credit. Recently, cyclical sectors and manufacturing-related sectors have outperformed, but we may see a pullback from this movement as the trend toward a more defensive credit stance continues to grow.