Iran’s Art of War: How the Treasury market became the real battlefield

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Photo by Martin Pelletier/PostmediaDuring my summer holidays in the southern United States, I visited a bar that had been converted from an old church. Covering the ceiling was the entirety of Sun Tzu’s The Art of War. Looking at the situation in Iran today, I can’t help but think they have read the same text.THIS CONTENT IS RESERVED FOR SUBSCRIBERS ONLYSubscribe now to read the latest news in your city and across Canada.Exclusive articles from Barbara Shecter, Joe O'Connor, Gabriel Friedman, and others.Daily content from Financial Times, the world's leading global business publication.Unlimited online access to read articles from Financial Post, National Post and 15 news sites across Canada with one account.National Post ePaper, an electronic replica of the print edition to view on any device, share and comment on.Daily puzzles, including the New York Times Crossword.SUBSCRIBE TO UNLOCK MORE ARTICLESSubscribe now to read the latest news in your city and across Canada.Exclusive articles from Barbara Shecter, Joe O'Connor, Gabriel Friedman and others.Daily content from Financial Times, the world's leading global business publication.Unlimited online access to read articles from Financial Post, National Post and 15 news sites across Canada with one account.National Post ePaper, an electronic replica of the print edition to view on any device, share and comment on.Daily puzzles, including the New York Times Crossword.REGISTER / SIGN IN TO UNLOCK MORE ARTICLESCreate an account or sign in to continue with your reading experience.Access articles from across Canada with one account.Share your thoughts and join the conversation in the comments.Enjoy additional articles per month.Get email updates from your favourite authors.THIS ARTICLE IS FREE TO READ REGISTER TO UNLOCK.Create an account or sign in to continue with your reading experience.Access articles from across Canada with one accountShare your thoughts and join the conversation in the commentsEnjoy additional articles per monthGet email updates from your favourite authorsSign In or Create an AccountWhen investors think about the war involving Iran, they instinctively focus on oil. That’s understandable because every conflict in the Middle East immediately raises questions about crude supply, tanker routes and energy prices. What makes this episode different from past geopolitical crises is that the global economy is carrying record levels of sovereign debt and governments can no longer absorb inflation shocks the way they once could.This advertisement has not loaded yet, but your article continues below.Therefore, every dollar increase in the price of oil and refined products such as gasoline and diesel feeds inflation expectations, pushes bond yields higher and increases the cost of financing already massive fiscal deficits. While investors and commentators continue debating whether higher interest rates will solve the problem, the reality is that monetary policy cannot produce more oil or reopen disrupted supply chains. As long as the conflict continues, inflationary pressure remains embedded in the system and will continue to wreak havoc on both bond and equity markets.Canada's best source for investing news, analysis and insight.By signing up you consent to receive the above newsletter from Postmedia Network Inc.A welcome email is on its way. If you don't see it, please check your junk folder.The next issue of Investor will soon be in your inbox.We encountered an issue signing you up. Please try againThe Iranians understand this. In a world burdened by excessive debt, the critical battlefield is no longer confined to oil fields or shipping lanes. It extends directly into the U.S. Treasury market. If they have indeed studied The Art of War, they would know that Sun Tzu argued the highest form of generalship is to thwart an opponent’s strategy rather than confront its forces directly.While the United States possesses overwhelming military superiority, financial markets do not respond to military power alone. They respond to risk, uncertainty, inflation expectations, fiscal deficits and investor confidence. In today’s case, by refusing to capitulate to U.S. demands and prolonging the conflict, Iran may be exploiting the vulnerabilities of an already indebted global financial system, increasing pressure until it ultimately gains leverage at the negotiating table.This advertisement has not loaded yet, but your article continues below.We’re already seeing this in the relentless rise in Treasury yields at a time when the U.S. government is carrying record debt levels and facing enormous refinancing requirements. A market once considered the world’s ultimate safe haven has become a source of extraordinary volatility.What makes this dynamic particularly dangerous is its self-reinforcing nature. Modern markets are dominated by systematic investors, leveraged hedge funds, commodity trading advisors, volatility-targeting strategies and algorithms that respond almost instantly to price trends. Rising yields trigger risk reduction, risk reduction creates selling pressure, additional selling pressure pushes yields even higher. In effect, Iran is taking full advantage of these market participants to amplify the pressure throughout the entire financial system.We are, as a result, witnessing economic warfare in a modern form. You no longer need to confront an aircraft carrier directly when you can trigger reactions inside global capital markets that rapidly tighten financial conditions, pressure asset prices and increase borrowing costs.This advertisement has not loaded yet.This advertisement has not loaded yet, but your article continues below.While bond markets are responding, don’t kid yourself: equity markets are as well. While the headlines suggest the S&P 500 remains relatively resilient, the underlying market tells a very different story. September exposed just how narrow this bull market has become. Utilities, real estate investment trusts and other interest-rate-sensitive sectors have been hit hard as investors suddenly found themselves able to earn more than five per cent with virtually no credit risk. Large segments of the market have slipped into correction territory even as the major indexes remain near their highs.Investors have responded by crowding into a small handful of mega-cap technology companies tied to the artificial intelligence boom. The extraordinary concentration in these names has masked much of the damage taking place beneath the surface. However, even these companies are not immune if this conflict continues.This is because we are still at the front end of one of the largest capital spending cycles in modern history. Trillions of dollars will be required to build the data centres, power infrastructure, semiconductor facilities and networks needed to support the AI revolution. At precisely the moment investors are grappling with rising yields, elevated valuations, fiscal concerns and geopolitical uncertainty, they are also being asked to absorb an enormous wave of debt and new equity issuance to fund that growth.This advertisement has not loaded yet, but your article continues below.Perhaps this is exactly the type of strategy Sun Tzu had in mind more than 2,500 years ago. In a heavily indebted world, financial markets have become the soft underbelly of U.S. economic power. The big question is if the Trump administration is smart enough to offer the Iranians a Golden Bridge — a metaphor attributed to Sun Tzu — a way out for a very desperate and dangerous enemy that is feeling cornered.If not, the danger is that this cycle becomes self-reinforcing. The longer the conflict continues, the greater the risk that what began as a geopolitical event evolves into a full-blown financial event. Investors may be focused on missiles, drones and oil tankers, but the market’s verdict is being delivered elsewhere. Right now, it is being written every day on the Treasury yield curve.Martin Pelletier, CFA, is the author of Investing Through the Storm and a senior portfolio manager at TriVest Wealth, a team that is part of Wellington-Altus Private Counsel Inc. TriVest provides discretionary risk-managed portfolios, investment audit/oversight and advanced tax, estate and wealth planning. The opinions expressed are not necessarily those of Wellington-Altus._____________________________________________________________If you like this story, sign up for the FP Investor Newsletter.We apologize, but this video has failed to load.This advertisement has not loaded yet.Notice for the Postmedia NetworkThis website uses cookies to personalize your content (including ads), and allows us to analyze our traffic. Read more about cookies here. 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