Iran war continues to dominate markets

In itself this is a dangerous escalation. With China being the main recipient of oil coming from the Strait, it is easy to see how this action could bring back tensions between China and the US if this situation lasts too long. Fortunately, there has also been good news. Iran is said to have reached out to the US for renewed talks, and both parties are looking to extend the ceasefire to make room for this.

Credit markets are taking an optimistic view of the latest developments. Spreads continued to tighten this week, a trend that started at the beginning of this month after Trump retracted his deadlines to bomb Iran “into oblivion.” As both the US and Iran now appear to be looking for a deal, it seems the war has passed the escalation phase. In that sense, the credit market’s direction makes sense. However, spreads for investment-grade and high-yield corporate bonds are now back to close to where they started this year, and spreads on emerging-markets debt are even slightly tighter.

We believe that this is a highly optimistic view of the current macroeconomic backdrop. This is especially true for European and emerging-markets credits, considering the longer term challenges these regions may have on the energy front, even if a complete peace was achieved right now. The main implication from this is that spreads could be vulnerable in case of disappointments.

In contrast to credit spreads, US Treasury and Bund yields have not fallen as much. In particular, Bunds remain at levels higher than what has been seen for some time. To some extent, this divergence with credit spreads makes sense, because yields are more directly impacted by high inflation; and as long as there are no serious second-round effects, this impacts spreads less. Still, if the US and Iran are able to bring the conflict to an end (and crucially, for the Strait of Hormuz to reopen) there may well be room for yields to fall. Especially for shorter maturities, since in this positive scenario, the two or more European Central Bank rate hikes that the market is still pricing-in may well be priced-out again. Let’s see if this more positive sentiment can survive another weekend.