Last weekend, Iran launched hundreds of drones and missiles against Israel. This direct military strike by Iran against Israel is unprecedented. Israel will respond, but how and when is unknown.
Given the increased military and economic risks posed by the attack, market behavior so far has been remarkably optimistic. US stocks traded slightly lower, not because of the attempted attack on Israel, but because US stock markets were overbought. The stock markets were facing a correction and some consolidation; that's what's happening. What is surprising, however, is which “notices” actually represent a measurable risk and how some asset classes do not behave as common sense would suggest.
As a hedge against the consequences of the Israeli response, the market should logically buy large oil companies with very strong balance sheets and diversified asset portfolios. But stocks like Exxon Mobil and Chevron have been trading lower in recent days. Stocks should be outperforming the market, but that's not the case. The market is mispricing the risk.
Likewise, US government bonds typically recover strongly in times of crisis. When government bond prices rise, yields fall. Prices and returns develop in opposite directions. But the yield on the 10-year Treasury note has risen since Iran's attack on Israel. That's surprising. Where market action is logical is in the market for US dollars, the preeminent safe haven. The market values the US dollar efficiently.
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The most bizarre thing is the price movement in the global oil markets. Oil prices are stable. Logically, oil prices should be much higher. The world economy is based on oil. Iran exports about 1.5 million barrels per day, or about 1.5% of global demand. Equally important, Iran has demonstrated in the past that it and its proxies are capable of degrading and partially closing the Strait of Hormuz, a key chokepoint for up to 20% of global oil supplies.
Make no mistake, Israel will respond. The stock market and the U.S. Treasury bond market have not priced in what appears to be inevitable: an escalation of military action in the Middle East.
James Rogan is a former U.S. foreign service officer who later worked in finance and law for 30 years. He writes a note every day.
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