A further escalation in Iranian-Israeli tensions could take oil prices above $80 and would mean more upside for the US dollar. The Federal Reserve was already likely to keep rates on hold through the third quarter and the latest developments only reinforce that
What’s Happened
Israel has launched coordinated strikes on Iran’s primary nuclear and ballistic missile facilities, as well as targeting senior IRGC commanders and nuclear scientists. In response, Iran has retaliated with approximately 100 drones aimed at Israeli territory and marking a major escalation in regional hostilities. Israel has declared a state of emergency, framing the strikes as pre-emptive and warning of further operations.
Whilst the US has not been directly involved, Iran has accused Washington of complicity and may target American assets in the region. Previously, the US had restrained Israeli action amid ongoing nuclear negotiations, but those talks now appear stalled.
Equally, maritime security risks have surged in the Strait of Hormuz, the Persian Gulf, and surrounding waters, critical chokepoints for global oil and LNG trade. Although energy infrastructure has not yet been targeted, the threat of future strikes could disrupt supply chains and further drive up prices. Any restrictions to maritime trade are equally likely to have longer-term implications should Tehran determine that a blockade is an effective method of retaliation which avoids direct targeting of regional US assets.
Meanwhile, the International Atomic Energy Agency’s (IAEA) recent censure of Iran has further isolated Tehran diplomatically. Iran now faces a pivotal choice: pursue a nuclear breakout, with a weapon potentially achievable within months, or return to negotiations under the weight of severe economic sanctions. A breakout would significantly alter the regional balance and almost certainly trigger US military intervention.
With further Israeli strikes likely, Iran’s drone attack is unlikely to be Tehran’s final response. Tehran must weigh the need of reasserting deterrence, taking into account a depleted proxy network, against the risk of provoking a broader war and direct US involvement. While past behaviour suggests Iran may ultimately de-escalate to preserve regime stability, the situation remains highly volatile.
The Impact on Energy Markets and Potential Escalation Scenarios
An elevated level of geopolitical uncertainty requires energy markets to price in a large risk premium given the potential for supply disruptions. The strikes on Iran initially saw oil prices rally 13%, although markets have given back some of these gains. In the absence of any actual supply disruptions to Iranian oil flows, we suspect the rally will continue to fizzle out.
However, the market will need to price in a larger risk premium than it was prior to the attacks, at least in the short term, leaving Brent to trade in a $65-70 range.
Any escalation that leads to a disruption in Iranian oil flows will be more supportive for prices. Iran produces roughly 3.3m b/d of crude oil and exports in the region of 1.7m b/d. The loss of this export supply would wipe out the surplus that was expected in the fourth quarter of this year and push prices towards $80/bbl.
However, we believe prices would finally settle in a US$75-80/bbl range. OPEC sits on 5m b/d of spare production capacity and so any supply disruptions could prompt OPEC to bring this supply back onto the market quicker than expected.
A more severe scenario is if escalation leads to a disruption in shipping through the Strait of Hormuz. This could impact oil flows from the Persian Gulf. Almost a third of global seaborne oil trade moves through this chokepoint. A significant disruption to these flows would be enough to push prices to $120/bbl.
OPEC’s spare capacity would not help the market in this case, given that most of it sits in the Persian Gulf. Under this scenario, we would need to see governments tap into their strategic petroleum reserves, although this would only be a temporary fix. Therefore, significantly higher prices are needed to ensure demand destruction.
This escalation also has ramifications for the European gas market. However, to see gas prices moving significantly higher, we would need to see the worst-case scenario play out - disruptions in the Strait of Hormuz. Qatar is the third-largest exporter of LNG, making up around 20% of global trade.
And all this supply must move through the Strait. The global LNG market is balanced now, but any disruptions would push it into deficit and increase competition between Asian and European buyers.
The Economic Impact and What It Means for Central Banks
The spike in oil prices threatens to disrupt the current narrative surrounding US inflation, which has proven more benign than expected in the face of US tariffs. So far, goods inflation has stayed remarkably calm, while price pressures within services, which represent three-quarters of the core CPI basket, have begun to ease.
We don’t think that will last. Inventory buffers may have allowed firms to put off decisions about raising prices, but that won’t be the case for much longer. We expect to see bigger spikes in the month-on-month inflation figures through the summer. The Fed’s recent Beige Book cited widespread reports of more aggressive price rises coming within three months. Higher oil prices only add to that.
Ten years ago, central banks, including the Federal Reserve, would have viewed an oil price spike as a dovish factor for interest rates. Weaker growth typically outweighed concerns about a short-lived spike in inflation. But that thinking has changed considerably since the Covid pandemic.
In Europe, the 2022 natural gas and oil price spike fed a long-lasting pick-up in service-sector inflation. Officials at both the Federal Reserve and Bank of England have warned about a similar feedback loop emerging today. The Bank for International Settlements has warned central banks that it will be harder to simply look through supply shocks.
Those fears may be overblown. Through both the pandemic and 2022 energy price shock, the broader economic environment was ripe for inflation to take off. In both cases, governments offered substantial fiscal support to offset the impact, a task made much harder today by higher interest rates and jittery financial markets.
And the jobs market was considerably stronger too. In 2022, there were two job vacancies for every US worker. Now there is only one, which is below pre-pandemic levels. The scope for a resurgence in wage growth is more limited.
Higher oil prices clearly reduce the chances of the Federal Reserve cutting rates in the third quarter. We already felt those chances had fallen over recent weeks. But by the latter stages of the year, we think the impact of tariffs on inflation will begin to wane and service-sector disinflation will have gathered pace.
At the same time, the economic hit from the US trade war will have become more apparent in areas like unemployment. We expect the first Fed cut in the fourth quarter, potentially starting with a 50 basis-point cut in December. A rapid string of cuts could take rates down to 3.25% by mid-2026.
These developments also make life harder for the European Central Bank. Eurozone inflation has been muted over recent months thanks to lower energy prices. That risks changing now, and higher costs are yet another concern for the manufacturing sector.
It’s a further hit to confidence, which is already weak thanks to broader geopolitical and economic uncertainty. Consumers are saving more, and firms are delaying investment. A further escalation in Middle East tensions would add to that negative sentiment and weigh on growth.
If that happens over a prolonged period, the eurozone outlook becomes more stagflationary. An ECB scenario shows that a 20% spike in energy prices could cut growth by 0.1pp in both 2026 and 2027. Inflation would be 0.6 and 0.4pp higher, respectively, relative to its base case.
While we’re not yet in this more extreme scenario, it makes it tricky for the ECB to respond. Higher energy price volatility means the ECB will look even more closely at underlying inflation. We expect one more ECB rate cut in September, though President Christine Lagarde will be happy that she can use the recently announced pause to see how things play out before deciding whether to cut rates below neutral.
Impact on FX
The dollar has rebounded on the Israel-Iran developments overnight, but is still far from recovering losses from earlier this week. We think the impact on equities (US stock futures down) is holding back dollar gains, as the greenback now has changed its sensitivity to risk sentiment.
Should tensions spiral into a broader conflict and oil prices rise further, there should be more upside room for the dollar, which is already oversold and sharply undervalued in the near term. But the dollar’s relatively contained rally this morning is another testament to the fact that it has lost some of its safe-haven status, and a lingering structural bearish bias remains.
That is entirely due to US domestic factors, so we doubt an external event (like geopolitical tensions) will fix the damage done to the dollar. Expect active buying on the dips in EUR/USD on any indication of a de-escalation. The Japanese yen, in our view, remains the most attractive hedge.
Impact on Market Rates
Markets had already responded on Thursday to escalating tensions around Iran, with German government bonds reaffirming their safe-haven status as they began to outperform swaps. Following the actual news of military strikes on Iran, the market’s knee-jerk flight-to-safety reaction soon faded and gave way to concerns surrounding the monetary policy implications - the curve bear flattening points to stagflationary worries, as does the rise in shorter-dated inflation swaps.
In the broader context, the rates market’s reaction will likely remain muted, however. Tariff policies, fiscal concerns in the US and spending prospects in the EU have already made for an uncertain environment – the escalation in Iran only adds to the noise. Markets are still eyeing one more cut from the European Central Bank to 1.75%, though have started to trim chances of the ECB moving beyond that. In longer rates, the 10y swap rate rose somewhat above 2.5% again, but remains well within recent ranges.
Impact on Credit Markets
Recently, credit markets have absorbed and ignored all external factors of concern. Abundant liquidity has taken down significant supply whilst spreads have tightened considerably at the same time, often to the tightest levels this year. The effect on credit spreads should therefore be muted, for the time being, as these strong technicals continue to drive spreads whilst external factors are being ignored. The initial spread reaction is to widen a little, but if these geopolitical tensions do not escalate, the credit market can quickly revert to its tightening trend.
However, longer-term uncertainty for the corporate balance sheet dominates, and higher commodity prices and inflation impact margins - another credit negative. Cyclical and manufacturing-related sectors have outperformed of late, but we could well see a retracement of that move as the case for a more defensive credit stance continues to build.
Disclaimer: This publication has been prepared by ING solely for information purposes irrespective of a particular user’s means, financial situation or investment objectives. The information does not constitute investment recommendation, and nor is it investment, legal or tax advice or an offer or solicitation to purchase or sell any financial instrument. Read more