Trump Keeps Iran Nuclear Strike Option Open, Reinforcing Oil Risk Premium

What happened

Former US President Donald Trump reiterated that he would not use nuclear weapons against Iran and does not expect to send ground troops into the country. However, he kept open the possibility of a strike on 'Pickaxe Mountain' (Kuh-e Kolang), an underground complex near Natanz that analysts link to Iran’s nuclear program. Trump mentioned being in discussions with Russia and China about denuclearization, without providing details. These statements follow Trump's assertion last week that the US would not attack Iran before the November midterm elections, even as CBS News reported Pentagon plans to use massive conventional bombs against Iranian military sites, if ordered.

Why it matters

Trump's remarks, while largely restating previous positions, are significant because they keep the threat of a strike on Iran's nuclear infrastructure as a live option after the pre-election pause. This sustains the geopolitical risk premium in energy markets. Ruling out nuclear weapons and ground troops reduces tail risks, but the possibility of air strikes remains on the table. The key question for markets is what any escalation would mean for the Strait of Hormuz, a vital route for global oil transport. Disruptions in the strait and attacks on tankers have already been a concern, with US crude trading near $97 a barrel, close to the $100 mark, despite accelerated IEA stock releases.

Market impact

• Interest rates and bonds: The sustained geopolitical risk premium, especially if it results in higher oil prices, tends to fuel inflation expectations. This, in turn, could lead to an increase in Fed rate hike expectations, pushing Treasury yields higher.
• Dollar and exchange rates: In a scenario of escalating tensions and increased global uncertainty, the US dollar tends to strengthen as a safe-haven asset. Emerging market currencies, such as the Brazilian real, may depreciate against the dollar due to risk aversion and the flight to safety.
• Equities: Increased geopolitical risk and the prospect of higher inflation and interest rates are generally negative for global stock markets. Sectors more sensitive to energy costs and interest rates may be particularly affected. However, energy companies might see a marginal benefit from higher oil prices.
• Commodities: Oil is the most directly impacted asset. The continued threat of a strike and the possibility of disruption in Hormuz sustain a risk premium, with the potential to push prices above $100 a barrel. Gold, traditionally a safe haven, has been pressured by higher interest rate expectations rather than benefiting from tensions.
• Brazil: Brazil, as a net oil importer, may face additional inflationary pressures due to higher energy prices. This could complicate the Copom's monetary policy, potentially limiting room for interest rate cuts or even forcing a more hawkish stance. The real tends to depreciate in a global risk-off environment.

What to watch

Key markers to watch include any sign of progress in contacts between Washington and Tehran before the midterms, further attacks on shipping in the Strait of Hormuz, and whether Washington's stated pause holds. Additionally, the evolution of global inflation data and statements from Fed members will be crucial for assessing the impact on interest rate expectations.

Scenarios

Base case: The pre-election pause holds, but the oil risk premium persists due to the threat of a post-election strike. Oil prices remain elevated but without immediate spikes, with the dollar slightly strengthened. Risk scenario: Escalation of tensions leads to air strikes or significant disruptions in the Strait of Hormuz. Oil prices surge above $100, fueling inflation and raising interest rate expectations, with a strong dollar appreciation and a decline in equity markets.

Original source: ForexLive (InvestingLive). For information only, not investment advice.