Iran dragging its feet
The Strait of Hormuz standoff continues.
Bottom line
The US/Israel joint invasion of Iran was expected to be a limited, four-to-six-week engagement, wrapping up well before we celebrate America250 on July 4. But it crossed the 100-day mark last weekend with no apparent end in sight, marked by a fragile ceasefire and largely unproductive peace negotiations. In fact, yesterday, Iran shot down a US Apache helicopter that was patrolling over the Strait of Hormuz. While both pilots were uninjured, President Trump retaliated. So, what impact might this seemingly ceaseless war, higher energy prices and rising inflation have on financial market performance and the midterm elections?
Wide chasm in negotiations The US demands are clear. Iran must agree to the complete, immediate and safe reopening of the Strait of Hormuz; agree to never pursue nuclear weapons; dismantle its three main nuclear facilities; surrender all 900 pounds of highly enriched uranium to the International Atomic Energy Agency; suspend its ballistic missile production; and stop funding its regional proxies – Hamas in the Gaza Strip, Hezbollah in Lebanon and the Houthis in Yemen.
Iran’s demands are completely different. It wants recognition of sovereignty over the Strait of Hormuz; payment of war reparations directly from the US (and through navigation fees/tolls for passage through the Straight); the right to enrich uranium; the end of international sanctions; and protection for its proxy groups.
Iran’s maritime leverage The Strait of Hormuz is an international waterway. Before the Iran conflict, about 140 ships — and 20% of the world’s oil — passed freely each day. The US and Israel have destroyed much of Iran’s naval, air force and communications capabilities. But Iran has closed the critical chokepoint with strategic use of swift boats, naval mines, missiles and drones. It will allow safe passage for one dollar a barrel. The most common vessel for moving oil from the Middle East is a Very Large Crude Carrier (VLCC), which can carry two million barrels of oil. That can mean the toll could reach $2 million per ship, meaning Iran might collect more than $100 billion over a year. That is somewhat moot for the time being as the US has countered with a naval blockade hemming in Iranian ships while escorting others through. At its peak, an estimated 2,000 VLCCs were stuck in the Persian Gulf. The escorts have reduced this backlog to around 800 ships.
Plan B in the Persian Gulf The US, Israel, Europe, and their Middle East allies agree that Iran must not have nuclear weapons and that the Strait of Hormuz must be open and free.
The bottleneck harms Asia and Europe more as they rely more significantly on the crude oil and natural gas exported from the Middle East. In contrast, the US is the largest energy producer in the world at 13.7 million barrels of oil each day; Saudi Arabia produces about 9.5 million barrels; and Russia produces 8.8 million barrels. On Sunday, OPEC-Plus announced that it will raise its oil output targets by 188,000 barrels per day starting in July — the fourth consecutive month it has increased production. But that is primarily symbolic, as much of this oil may be unable to emerge from the Strait at present. To counter this, the US has reduced its Strategic Petroleum Reserve by about 14% to 357 million barrels in recent weeks, and some Middle Eastern oil producers are building expensive new pipelines to shift oil to waterways other than the Persian Gulf.
Impact on energy prices... Around the onset of the conflict, crude oil prices (West Texas Intermediate, or WTI) spiked 85% (from $65 per barrel on February 27 to $120 on March 9), but they have declined to about $89. Lagging gasoline prices soared 53% initially (from $2.98 per gallon at the end of February to a four-year high of $4.56 in May) but have fallen 9% to around $4.16.
...and on inflation US price pressures declined from 40-year highs to four-year lows over the past three years. But the recent war-related spike in energy prices reversed this progress, particularly with nominal retail inflation:
- Nominal CPI retail inflation spiked to a 40-year high of 9.1% year-over-year (y/y) in June 2022 and plummeted to a nearly five-year low of 2.4% y/y in February 2026. But March leapt to 3.3%, April soared to a three-year high of 3.8% and May rose to a three-year high of 4.2%.
- Core CPI retail inflation, which removes volatile energy and food prices from its calculation, spiked to a 40-year high of 6.6% y/y in September 2022 and declined to a more than five-year low of 2.5% y/y in February 2026. But March rose to 2.6%, April increased to 2.8% and May inched up to 2.9%.
- Negative real wage growth With average hourly earnings rising 3.4% y/y in May and nominal CPI up 4.2% y/y in May, real wage growth declined 0.8% last month, also largely due to rising energy prices.
- Core PPI wholesale inflation spiked to a 40-year high of 9.7% y/y in March 2022 and plunged to 3.0% y/y in October 2025. But it soared to 3.9% in February 2026, 4.0% in March and 5.2% in April. May is expected at 5.4%.
- Core PCE inflation peaked at a 39-year high of 5.6% y/y in Sep 2022 and declined to a four-year low of 2.6% in April 2025. But it increased to 3.0% in February 2026, 3.2% in March and a three-year high of 3.3% in April. In its March 2026 SEP, the Federal Reserve said it expects inflation to reach its 2.0% target by the end of 2028.
Equity market rebound After an initial selloff in March, stocks soared in April and May, as equity investors looked through the near-term uncertainty to its eventual resolution. But if the Iran conflict lingers, another correction is possible:
- S&P 500 declined 10% from January 28 to March 30 and rallied 20% to a new record high of 7,621 on June 2.
- Nasdaq declined 13% from January 28 to March 30 and soared 35% to a new record high of 30,762 on June 3.
- Russell 2000 declined 12% from January 22 to March 30 and rallied 22% to a new record high of 2,944 on June 4.
Bond investors more realistic Fixed income investors, however, resisted the urge for a flight-to-safety rally. They seem to be focused on the elevated energy prices, the spike in inflation and the uncertain pace of Iran negotiations:
- Ten-year Treasury yields soared from 3.94% on February 27 to 4.67% on May 19.
- Two-year Treasury yields leapt from 3.37% on February 27 to 4.16% on June 8. With the upper band of the fed funds rate at 3.75%, it is unlikely that the Fed under new Chair Kevin Warsh will be able to reduce interest rates anytime soon, until the Iran conflict is resolved, energy prices normalize, inflation cools and benchmark two-year Treasury yields decline to at least 3.5%. We expect that the Fed will remove its easing bias from the statement released after the Federal Open Market Committee meeting on June 17.
Savvy negotiators Iran is clearly playing for time. The Iranian theocracy is taking a page from President Trump’s “Art of the Deal,” and it certainly seems they have studied legendary North Carolina basketball coach Dean Smith’s four-corner stall. They know that Trump’s political approval ratings are dismal, that Congress is trying to wrest control of the war from him and that the midterm elections are only five months away. Iran believes that if they keep the Strait closed and energy prices elevated, Trump may withdraw from the Iran conflict soon.
But patience is a virtue, and the closure of the Strait is a double-edged sword that has also decimated the Iranian economy heavily reliant on oil exports. Former US Secretary of State Condoleezza Rice wrote in the Wall Street Journal last week that “strategic patience is hard, and it isn’t always satisfying. But time is on the side of the US and its allies. Reaching no deal is fine. Reaching a bad deal isn’t.”
The Trump Administration and allies may decide to finish the job now, regardless of the near-term economic, financial market and political consequences, thus depriving the Iranian theocracy of a window to survive with nuclear ambitions intact.
Read more about our views and positioning at Capital Markets.