The Hormuz conflict How to price a prolonged conflict

The Iran-US conflict is likely to remain a recurring cycle of escalation and negotiation, keeping energy markets hostage to the diplomatic process and gradually increasing the macro impact as buffers are depleted. For investors, this implies a higher floor for energy prices and bond yields, a cautious central-bank backdrop, and near-term support for the US dollar.

The cease-fire following the recent war between Iran and the United States (US) was always fragile, a fact underscored by the resumption of tit-for-tat hostilities in mid-July.

War as the continuation of politics by other means

As the Prussian military theorist Carl von Clausewitz argued, wars are often political disputes pursued through military means. The Memorandum of Understanding (MOU) that ended the war outlined a pathway toward resolving disputes, but its ambiguity made a lasting ceasefire difficult to sustain.

The MOU’s first objective was to reopen the Strait of Hormuz, yet it deliberately left unresolved the question of Iranian control. The renewed fighting is therefore best understood as a violent negotiation over that issue: Iran insists on its right to regulate and control shipping, while the US seeks to preserve unrestricted transit.

The US has the military capability to seize control of the Strait or even threaten the regime, but not the willingness to bear the economic, political and military costs, particularly ahead of the mid-terms. Iran is therefore betting that its tolerance for short-term pain and willingness to escalate (including by way of the Houthis in the Red Sea) will force Washington to concede. Our base case is that, after a period of pressure and brinkmanship, the US accepts a compromise wherein it recognises some Iranian role in the management of the Strait, and tensions ease.

Our base case is that sustained pressure and brinkmanship ultimately lead to a compromise under which the US accepts some Iranian role in the Strait’s management and tensions ease.

What follows depends on how many additional concessions Iran seeks. The nuclear programme and a host of other issues remain unresolved, creating scope for repeated cycles of escalation and de-escalation. Because Iran’s principal source of leverage over the US is its ability to disrupt markets, periodic bouts of market stress are likely to be a feature of the diplomatic process.

The three paths from here

The best-case scenario is a quick return to the ceasefire and an uneventful negotiation of remaining issues (15%). The most likely scenario is a recurring cycle of pressure, negotiations and partial agreements until a broader settlement is reached (65%). The worst scenario is a major escalation, triggered by a miscalculation by either side or a decision by the US to again make the war existential for the Iranian regime. This would imply a prolonged supply shock and a global stagflation hit (20%) (Figure 1).

Macro: Watch the shock absorbers

The macro impact of the war has been contained so far because markets adapted. Around half of the 15 mbpd of crude previously flowing through the Strait was rerouted, primarily through Saudi Arabia’s East-West Pipeline. Additional supply from outside the region and inventory drawdowns further reduced the shortfall, limiting the amount of demand destruction required to rebalance the market. The brief interlude after the MOU allowed a partial restoration of flows. However, these have again dried up (Figure 2).

Our baseline expectation is for episodic supply disruptions followed by partial restoration of flows through the Strait, much like the pattern observed recently. However, with inventories gradually being drawn down in the background, each successive disruption is likely to have a faster and larger impact on both markets and the broader economy. Refined product markets, which are tighter and more vulnerable than crude oil markets, remain the weakest link. The real tail risk emerges if inventories at critical nodes such as airports, power plants, or industrial hubs are suddenly exhausted, triggering a non-linear and cascading economic damage.

The Houthis' threat of a "Saudi embargo" illustrates the broader risks of regional escalation. By targeting exports rerouted through the East-West Pipeline, they are threatening the very shock absorbers that have helped stabilize global energy markets.

Markets: Pressure is building and has further to run

Energy prices are moving higher again. Brent crude briefly returned to pre-conflict levels during the ceasefire but has resumed its ascent. Tightness in refined-product markets is even more pronounced. Unlike crude oil, product prices never fully retraced after the MOU was signed and have risen more rapidly as the agreement has frayed. The Brent 3-2-1 crack spread—a proxy for refining margins and the value of refined products—now stands 3x its pre-conflict level, while crude prices are only about 1.25x higher (Figure 3). European gas prices are already at Iran war highs.

Bond markets appear to be retaining a residual conflict premium. While 10-year Treasury yields tracked oil prices higher during the initial escalation, they proved far less responsive when crude retreated following the cease-fire. As a result, yields remain roughly 30 bps above levels that would have been implied by oil prices alone. With energy prices now rising again, Treasury yields are climbing back toward their conflict highs (Figure 4). The US 10-year yield recently reached 4.63%, just shy of its mid-May peak.

Investment implications: Oil, yields, equities, and USD

A feedback loop exists between markets and US-Iran tensions. Economic pain points—particularly gasoline prices and bond yields—shape Washington's tolerance for prolonged escalation. When energy prices and yields fall, the constraints on further escalation ease. When they rise, the pressure to de-escalate grows.

The practical effect is to make both energy and bond markets volatile and broadly rangebound. We expect oil prices to fluctuate in a $80-$110 range, equivalent to roughly $4.00-$4.70 per gallon for US gasoline. Bond yields are likely to exhibit a similar pattern, albeit with a modest upward bias until the conflict is definitively resolved.

We doubt gasoline prices can sustainably move above $5.00 per gallon, or US 10-year Treasury yields above 5.0%, without eventually forcing a compromise on Hormuz. A more severe outcome would likely require a mass-casualty event or another catalyst capable of materially increasing US willingness to bear the costs of confrontation.

Central banks are likely to remain cautious, with a bias toward hawkishness while geopolitical uncertainty persists. There is a tactical case for duration based on the view that the conflict cannot be sustained indefinitely. Structurally, however, the forces pushing long-term yields higher—including fiscal deficits, increased bond issuance, and geopolitical risk premia—remain firmly in place.

For equities, a higher-cost environment and more expensive financing conditions should favor companies with stronger margins, pricing power, and resilient earnings streams. In the near term, this points to continued large-cap leadership.

The US dollar should retain a positive near-term bias, supported both by its safe-haven status and the relative resilience of the US economy.