Almost two weeks into the war in Iran, financial markets are holding up surprisingly well.
The S&P 500 is down by only 1.5% since the start of the conflict and the 10-year Treasury yield stands at 4.23%, which is in line with our call of 4.25% being appropriate given risks around inflation. Considering the energy shock working its way through the American economy, things could be worse.
U.S. financial markets are paying attention to the war in Iran while taking a wait-and-see approach to threats to the global supply chain for petroleum-based products.
Equity market
The equity market has been dropping steadily since the beginning of the year, losing 3% of its value as of March 11. Volatility has increased, with the VIX index climbing to 25, its highest level since the April tariffs and, before that, the inflation shock and pandemic shutdown.
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When we compare the values of the S&P and the VIX to normal levels of risk priced into the market, we see a deceleration in their combined Z-scores, suggesting increased risk, but not yet at levels that might affect economic growth.
Bond market
While the threat of war had the bond market pricing in the safe-haven demand for dollar-based Treasury securities earlier in the year, the market is now pricing in increased inflation because of the war’s pressure on energy and food costs.
In the 12 days since the onset of hostilities, the yield on 10-year benchmark bonds has jumped 20 basis points, pushing it to the top of its recent trading range.
Volatility has also increased, pushing the MOVE index of Treasury bond market volatility higher to its long-term average. While not yet at crisis levels, the increase is a warning signal.
Money market
The money market has often acted as the canary in the coal mine, anticipating increased risk that will affect business lending, operations of monetary policy, and bond market trading and liquidity.
Current conditions remain somewhat accommodative now that it seems likely that the Federal Reserve will hold off on any rate moves at its March 18 meeting. The next test will be the Fed’s response to the severity of inflation.
The takeaway
Overall financial conditions as measured by the risk priced into equity, bond and money markets remain somewhat accommodative but less so because of the war in the Mideast.
This suggests that if hostilities continue to halt the flow of petroleum products out of the Mideast, we could expect slower growth as the global economy prices in the increased cost of energy and petroleum products.
