Oil jumps as Israel strikes Iran

Israel struck Iranian military infrastructure and strategic installations on 13 June, and crude oil shot up. Brent climbed back towards ninety dollars a barrel. Traders added a geopolitical risk premium to global bond and inflation-swap curves, and the summer hope of steadily falling inflation took a knock.

The attack was far larger than the exchanges of fire between the two countries last year. Israeli aircraft hit nuclear sites, including the enrichment plant at Natanz, and killed senior military commanders and nuclear scientists. Iran answered with waves of ballistic missiles aimed at Israeli cities, and the exchanges have continued every night since. Israel has also struck parts of Iran's energy system, including a facility at the South Pars gas field and a fuel depot near Tehran, which brought the conflict closer to the oil market than markets had assumed on the first day.

Breakevens move first

Trading desks repriced short-dated inflation swaps straight away, pushing up one-year and two-year breakevens as energy costs rose. For bond investors an oil spike is an awkward kind of shock. It comes from the supply side and cannot be absorbed without pain. Dearer crude drains household income into petrol tanks and utility bills while pushing headline prices higher, and that makes it hard for central banks to cut rates.

How the shock travels

The link from crude to swaps is direct. An inflation swap pays the realised rise in the consumer price index, and over a one- or two-year horizon the biggest swing factor in that index is the price of petrol. Petrol pump prices follow crude within weeks, so a jump in Brent feeds almost mechanically into expected headline inflation for the coming year. Longer-dated breakevens move less, because investors assume central banks will lean against any lasting effect.

Central banks face the same arithmetic from the other side. The Federal Reserve meets this week with its policy rate at 4.25-4.5 per cent and with officials already worried about the price effects of tariffs. An oil shock on top gives the hawks another reason to wait. The European Central Bank, which cut its deposit rate to 2 per cent earlier this month, is less exposed to the dilemma because euro-area inflation is already close to its target, but it too will be slower to cut again if energy prices stay high.

All eyes on Hormuz

What sovereign bond spreads are mostly pricing is the risk to shipping through the Strait of Hormuz, where twenty per cent of the world's petroleum supply passes every day. A sustained threat to traffic there would cause an energy shortage on a scale rarely seen.

The strait also carries a large share of the world's liquefied natural gas, almost all of Qatar's exports among it, so a disruption would reach European and Asian gas and power prices as well as oil. Saudi Arabia and the United Arab Emirates have pipelines that can bypass the strait for part of their exports, but their capacity is well short of the volumes that normally sail through. Tanker freight rates from the Gulf jumped in the days after the strikes, a sign that shipowners are already charging for the risk.

Lessons from Abqaiq

Recent history suggests spikes of this kind can fade quickly. In September 2019 drones and missiles struck the Saudi processing plant at Abqaiq and knocked out about half the kingdom's output for a time. Oil posted one of its biggest daily jumps on record, then gave back most of the gain within weeks as Saudi Aramco restored production faster than expected. The episode showed that markets price the worst case first and then retreat when physical supply keeps flowing.

The earlier shocks that did lasting damage, in 1973, 1979 and 1990, involved sustained losses of supply rather than a threat to it. The distinction matters for bond investors. A premium that reflects fear can vanish in days; one that reflects barrels actually lost can stay in prices for a year or more.

Why a closure is unlikely

The strongest case against a lasting shock is that closing Hormuz would hurt Iran as much as anyone. Iran's own oil exports, most of which go to China, pass through the strait, and Beijing is the one major power with some influence in Tehran. Even during the tanker war of the 1980s, when both Iran and Iraq attacked ships in the Gulf, the strait never shut completely. OPEC producers have also been adding supply this spring, and there is spare capacity in Saudi Arabia and the Emirates, though much of it sits behind the same chokepoint.

That reasoning argues for a smaller premium, not for none. The conflict is escalating night by night, American involvement is openly debated in Washington, and a direct attack on Gulf export infrastructure or on shipping would change the picture within hours.

Signals for bond desks

The indicators to watch are tanker traffic through the strait, war-risk insurance premiums for ships calling at Gulf ports, any strike on Iranian export terminals, and the Fed's statement and projections this week. Bond investors now face an energy shock they cannot easily hedge. Until the danger to Hormuz recedes they will probably demand a steeper term premium, and longer-dated yields will stay under upward pressure. If shipping keeps moving for the next few weeks, the oil premium is likely to fade, as it did after Abqaiq, but the term premium on long bonds will be slower to come down.