By Bas van Geffen, Senior Macro Strategist at Rabobank

Nowhere To Run

There don't appear to be many safe havens as the situation in Middle East continues to evolve. Not in markets, and not in the region either. At the time of writing, Israel has launched a new strike on Iran. And the US is considering arming Kurdish forces, trying to convince them to take part in a ground offensive against the regime.

Iran, meanwhile, has retaliated not only against the US and Israel, but against various countries in the region and against both military and civilian targets. Maybe this is simply an attempt to sow more chaos as the Iranian regime feels it is on its last legs. Or, perhaps, this is an attempt to convince its neighbors to appeal to the US to stop further operations; a signal that more of these attacks may happen if the US doesn’t.

Yet, if this was the plan, then it has backfired. Iran may have drawn its neighbors into the conflict – and they may side with the US instead. Saudi Arabia may attack Iran soon, Qatar reportedly already has. That’s quite the shift: it effectively sees them side with Israel in this conflict.

Iran’s strikes have reached as far as Cyprus, which means the EU is now involved too – if its energy security wasn’t a reason yet. However, European leaders remain divided on how to deal with the situation. The UK, Greece and France are scrambling to bolster Cyprus’ defences. Elsewhere, Spain has denied the US access to its military bases for air strikes.

That angered President Trump, who has threatened to cut trade ties with Spain. This follows on his Greenland threats earlier this year, and the recalibration of the US tariff structure after the Supreme Court invalidated many of Trump’s original tariffs.

The spat also raises the question whether the US is willing to protect European ships, or ships headed for the continent. President Trump has announced that the navy will escort tankers and freighters through the Strait of Hormuz, as a surge in petrol prices adds to US inflation fears. However, does that protection apply to all ships, or just to US allies? And does the EU have the capacity to protect its own tankers, if necessary? A French carrier does not suffice, but Europe does have some other assets in the area already. In fact, the US may lack the required assets, such as minesweepers, implying it may need its allies to back its pledge with the required muscle.

The effective shuttering of the Strait of Hormuz also poses a dilemma for China. What options does the country have? Escalate too, in order to distract the US and draw it away from the region? Or will Beijing work with Washington to end the conflict as quickly as possible and/or to safeguard energy flows through the Strait?

The longer world leaders take to effectively reopen the Strait of Hormuz, the more backlogs in energy supplies will build. So, thus far, markets have largely traded the Middle East war as an inflation risk. Money markets across the globe priced in tighter monetary policy – in the case of the Fed and Bank of England that means fewer rate cuts are being priced, but EUR money markets are now pricing in around 40% odds that the ECB may have to hike rates before the end of the year.

The inflation shock in the aftermath of the Russian invasion of Ukraine is clearly still in peoples’ minds. And yesterday’s Eurozone inflation data probably did not help either. At 1.9% y/y in February, the inflation rate still ran slightly below the ECB’s target, but prices rose faster than the 1.7% that had been expected – and that’s before any real disruptions to energy supplies. We estimate that recent energy price increases could add about 0.5pp to Eurozone inflation. This would see inflation average 2.3% this year, instead of undershooting the ECB’s target.

But if monetary policymakers do prioritize the inflation risks, where does that leave the economic outlook? Equity markets were deeply in the red yesterday, and a 12% drop in the Korean KOSPI index today suggests that global equity markets may not have bottomed out yet.

Rising energy costs may hit all sectors eventually, and aluminium and fertilizer prices are already being affected. But energy-hungry AI data centers are another key sector that comes to mind.

Governments may step in to shield households and companies from surging energy prices, like they did a couple of years ago. However, that will weigh on public finances, while fiscal space is already limited. Long-term sovereign bonds have taken a hit as a result, both in terms of outright yields, and in terms of swap spreads.

And in other markets, too, there appears to be little to no escape. Traditional safe havens, like gold, are not playing their usual part. Curiously, the metal has fallen 5% from its intraday peak at the start of this week. Considering the sharp appreciation of the DXY index, dollar liquidity appears to be king.