This could prove to be America’s Achilles’ heel in the Iran war

2026-03-04 - 18:03

In a strange way, markets could come to be a surrogate institutional check on a country that otherwise doesn’t know restraint The missiles are again flying and a thick fog of war has descended over the Middle East. US President Donald Trump has said it might take four to five weeks or longer to achieve America’s objectives, whatever those are. During a hot war, that’s an eternity in the world of mercurial financial markets. So far, however, markets have been remarkably sanguine, perhaps, as the excellent Yves Smith posits, because “bigotry and Western narrative control were able to shore up the idea that this would be a short conflict and that Iran would return to the negotiating table after the US broke its legs, or better yet fall quickly into civil unrest, making regime change or balkanization possible.” Energy markets are the first port of call Will the relative resilience of markets last? Everyone is of course watching the Strait of Hormuz, and more generally, oil prices. In these types of crises, it’s the oil price that other asset classes take their cues from. Iran has threatened any vessel that passes through, while Trump has offered to insure said vessels “at a reasonable price” with a US Navy escort to boot. Oil prices have drifted higher but the movements have so far been disciplined – much more so than many expected. A long disruption is not being priced in. It certainly helps that the US is the largest crude producer in the world and (usually) the third largest exporter. This means that any blockade chokes Asia and Europe first, whereas America has a buffer – one, I might add, it didn’t have in previous conflagrations. Read more Iran under fire: Lessons Moscow cannot ignore Perhaps more worrying is the situation with natural gas. Europe’s natural gas prices jumped by about 30% in the wake of an attack on QatarEnergy LNG processing units. There is no easy solution here. Qatar supplies 20% of the world’s LNG; if that supply disappears, an already tight market will see prices explode. Norway’s energy minister has already hinted that Europe might, tail between legs, come back to Russian energy. War is always disruptive, and when that war is in the Middle East, energy markets come into sharp focus. We have seen this on many occasions. It is indeed an acute pressure point for the US – and the world – and has been for decades. Right now, markets are basically trading headline to headline. But even in these head-swirling times, it pays to step back from the noise and flashing headlines and look at things a little more structurally. The cost of financialization One of the defining features of fading hegemons is that they often harbor fatal weaknesses that can be concealed for a long time. In the case of the US, the erosion of industrial capacity and related financialization of the economy may prove to be just that weakness. The former long ago caused the US to become overly reliant on pricey, high-tech weapons at the expense of the quantity needed for a protracted engagement – not to mention the dependency on supply chains from China for the defense industry. Trump claims to have nearly “unlimited” ammunition stocks thanks to cutting Ukraine off. But many believe that if high-intensity strikes go on much longer, US stocks of certain critical missiles will start to run low. The US reportedly used about five years’ worth of Tomahawk missile production in the first three days of the war, and Patriot interceptors are known to be running low. It seems to be a race as to whether Iranian missile launchers can be destroyed faster than the American stockpile of interceptors depletes. But the financial side is no less important, even apart from shock moves in oil prices. As the US economy de-industrialized, it became increasingly financialized. This has many far-ranging implications, but one of them is that a large portion of national income is now tied to financial asset prices. A drop in asset prices thus reverberates far and wide and triggers numerous knock-on effects. An example of this is that even the US tax base is highly dependent on asset prices. Read more The Iran war could have unexpected consequences in Ukraine The so-called ‘everything bubble’ of 2021 – when a wide range of asset classes saw record valuations – led to a large increase in tax receipts the following year (+21% year-on-year) when taxes on the income generated on these gains came due. However, when the Fed hiked interest rates in 2022, financial markets responded very negatively and asset prices went down. Sure enough, the following year tax receipts declined, and the federal deficit went sharply higher. Notice the very troubling negative feedback loop: higher interest rates suppress asset prices, thus leading to a lower tax intake by the government, while also entailing a higher debt-servicing expense. So a drop in asset prices forces the government to spend more to service its debt while at that exact moment decreasing the amount it collects in taxes. The result? More Treasury issuance, of course, and at higher interest rates. The moral of the story here is that longer-term the US cannot fiscally survive a massive decrease in financial asset prices. Also keep in mind that roughly half of American households now have direct exposure to equity markets through retirement accounts, mutual funds, or brokerage holdings. In previous eras, the health of the stock market was largely the concern of Wall Street. Today, it is entangled with the security of the middle class. This all might seem distant and abstract in the midst of a war. Next year’s tax receipts or the state of Americans’ 401(k) plans are the last thing on anybody’s mind in Washington today. But these are real structural constraints that have to be reckoned with. So far stock markets have only mildly drifted lower, but with no panic selling. If the selling picks up, watch how quickly it becomes a major headline. Read more How energy markets have responded to the Middle East war The power of a simple yield Even more sensitive than stocks is the US Treasury (UST) market, which is the true plumbing of the financial system. Higher UST yields tighten financial conditions everywhere, all at once. In a heavily indebted and leveraged system such as the US, rapid moves in this market are extremely dangerous. This is where the constraints start to be measured in hours. A very telling – albeit underreported – instance of this tremendous sensitivity to Treasury market dysfunction came last year. On April 2, Trump introduced his so-called Liberation Day tariffs, slapping an across-the-board 10% tariff on all imported foreign goods and larger “reciprocal tariffs” on the imports of dozens of countries that Trump claimed had “cheated” the US. “This is one of the most important days, in my opinion, in American history,” Trump proclaimed with his usual bluster in a speech on the White House lawn announcing the measures. The world watched with a mix of incredulousness, awe, and dread. It was a grand gesture, a reassertion of US power. Stock markets plunged immediately but Trump and his team weren’t deterred. On Sunday evening, April 6, Trump talked tough, saying “I don’t want anything to go down, but sometimes you have to take medicine to fix something.” Alas, the medicine would prove too bitter. At first, the big drop in stocks pushed investors scurrying into bonds and UST yields proceeded to actually fall (meaning prices rose) and reached 3.96% on Friday, April 4. So far, so good. On Monday, however, UST yields engineered a U-turn and started moving higher as the true implications of the radical tariffs started to dawn. The following day saw more of the same. By Tuesday afternoon, the 10y yield was approaching 4.30%. On Wednesday, the very day the tariffs were supposed to take effect, the 10y added another 10 basis points to 4.40%, putting the three-day gain at around 50 basis points. Read more Why are Americans killing and dying for Israel, again? Trump had seen enough. Or maybe he got a tap on the shoulder from some big players who were soon facing margin calls. Regardless, like an MMA fighter who taps out almost immediately after being put in a subtle chokehold to the bewilderment of the crowd, it only took a couple of days of disorderly market action for Trump to capitulate and cancel or postpone most of the tariffs in what can only be called a humiliating retreat. It was a telling moment for those who understood what had happened. Indeed, nothing makes regulators and politicians more nervous than dysfunction in the UST market, which can get out of control very quickly and suddenly cause markets to seize up. The US has shown repeatedly that it will intervene forcefully at the mere sight of UST market dysfunction. This is truly one of the Achilles’ heels of the US. Where are we headed There has so far been no sign of disorderly UST activity, but that doesn’t mean things are all clear. During times of chaos and uncertainty in the world, the US usually sees an inflow of money seeking a safe haven. Quite perversely, this happens even when the US is the cause of the trouble. To some extent, this has held true now: the dollar rallied sharply following the strikes on Iran. Nevertheless, UST yields have been creeping higher on fears of the inflationary effect of a more protracted war. Investors are thus caught between the normal safe-haven appeal of the dollar and fears of a surge in inflation that would hammer USTs (i.e. drive yields higher, prices lower). Read more Is Russia the key to ending the Iran war? This movement hasn’t been sharp enough to garner much attention, but the 10y is over the 4% mark as of this writing. Like old sailors who by a sixth sense can feel trouble in the breeze, some analysts wonder if something more disruptive might be brewing. Any definitive shift toward the inflationary case – such as major disruptions in energy flows – would likely push yields significantly higher. This would force the administration into the crucible of risking a major financial crisis to keep the war going. The US has long benefitted from the perception that it can blot out the sun with planes and missiles. Deterrence, once credibly established, can be maintained with smoke and mirrors – until, that is, somebody is willing to pay to see your cards. Until now, nobody has really called Washington’s bluff, although the Ukraine war has provided strong hints of this soft underbelly. Whether this will be the conflict that lays bare the deep fundamental weakness remains to be seen, but if markets start to think it is, things will move very quickly. The US and Israel are certainly acting with impunity, and there no longer seem to be any institutional checks on the ambitions of those prosecuting this war. But in a strange way, markets could come to be a surrogate institutional check. A country that can’t withstand a 50 basis-point move in its bond yields is by definition restricted. The precariously balanced edifice of American power depends on a tenuous financial equilibrium existing within a highly indebted and financialized economy. War is inherently destabilizing. The longer this goes on, the more that equilibrium will be tested.