How will the global economy be impacted by Operation Epic Fury?

The weekend saw the US and Israeli military launch joint air strikes on Iran, an unexpected development given the negotiations last Thursday in Geneva and scheduled talks for this week. Iran has subsequently responded by targeting US military bases, Israel and neighbouring Gulf states, tipping the whole region into uncharted territory and prompting a new period of global uncertainty given the potential impact on energy prices.

How did we get here? Talks between the US and Iran in recent weeks were set against a significant US military buildup in the region and threats of action if no deal was struck. Whilst we do not know the details of any of the recent negotiations, it would seem that President Trump felt that the sides were too far apart on Iran’s nuclear programme and ballistic missiles and hence ordered US military action.

The big question now is what happens next. Indeed there is a total lack of clarity over the medium-term, given that President Trump has not coherently articulated the US’s exact ultimate goal or how to achieve it. But there are two main US areas of interest.

Firstly, Trump has loosely called for regime change by calling on ordinary Iranians to rise up against the Tehran government, but there appears to be little in the way of a plan, at least publicly, on how that might be achieved. Even with the death of Ayatollah Khamenei and a number of Iran’s leadership figures, the Iranian establishment appears to still be very much in control.

Secondly, addressing Iran’s nuclear programmes had clearly been a focus running up to this weekend, so dismantling this and some of Iran’s other missile capabilities are also likely to be an aim. But whether this can be achieved through air power alone remains to be seen. In the aftermath of last June’s Midnight Hammer operation that saw US bombers strike Iranian nuclear enrichment facilities, President Trump claimed the mission a complete success and that Iran’s nuclear capabilities had been obliterated. However as later assessments had judged, capabilities were degraded, but not destroyed, raising questions over whether this latest operation will be any different. More cynically Trump’s goals could include attempts to control Iranian energy assets, similar to what has happened in Venezuela or to distract attention from domestic issues.

Whilst the US administration’s goals themselves are not clear, neither is the motivation for military action at this point in time. From a domestic point of view Trump’s approval rating has been languishing at a net -17, the lowest reading across both this and his first term. Meanwhile polls do not show public approval for action against Iran either: an Ipsos/Reuters poll showed support for such a move at just 27%. For the President there is a very real risk that the strikes on Iran backfire on him and the Republicans at this November’s mid-term elections, especially if the rise in energy prices proves to be persistent and adds to household affordability issues, a key election battleground.

What might happen next?

We would outline four possible scenarios, but ultimately acknowledge that there is a broad spectrum of outcomes which could be altered by multiple actors in the region:

• A 4-week US campaign: Trump has stated that Operation Epic Fury would last about 4-weeks. Therefore, a possibility is that Trump declares mission complete with Iran’s nuclear and missile capabilities destroyed at the end of this period. This is how US strikes on Iran effectively ended last June. Such a timeline would also fit with a number of expert assessments that the US cannot sustain the current tempo of activities in the region with current assets for more than a few weeks. A short conflict such as this may be what markets are pricing in given the relatively contained market moves this morning.
• Regime change: Such a scenario is seemingly what the White House would like to achieve, but broad consensus is that this is unlikely, especially with air power alone and with American ‘boots on the ground’ looking to be a definitive red line for Trump. Indeed, reported US intelligence assessments ahead of the strikes were that such an outturn was unlikely in the near-term even if Khamenei was killed, they concluded that he would likely be replaced by hardliners. Equally, there is no formal opposition group that could stand up against government forces such as the IRCG (Islamic Revolutionary Guard Corp). Nor is it evident, at least at the moment that a more moderate element of the government could step forward.
• Prolonged conflict: Whilst the White House may have a plan for how long the conflict lasts, developments can always change the dynamics and it is possible that events on the ground change and the US is drawn into a far longer operation than had been anticipated, as was the case with Iraq and Afghanistan. For the global economy and markets such a scenario would pose even greater question marks over energy supplies.
• Regional conflict: To quote an old military maxim, ‘no plan lasts first contact’, which in this context could be analogous to unforeseen consequences and the situation spiralling out of control, potentially drawing in other Gulf nations turning this into a regional conflict. So far Gulf countries have not responded directly to the Iranian missile strikes of recent days. However Iranian drone impacts on Saudi and Qatari energy infrastructure this morning have resulted in a much stronger tone and talk of a response. Another risk is that the strikes on the Iranian leadership degrade the government so much that the country breaks down in to rival groupings and a civil war, not unlike Syria. This for the Middle East would also represent a lasting and chaotic threat to regional stability.

How have financial markets reacted?

Financial markets have certainly reacted to the news, across all major asset classes. A key focus is, naturally, the oil market: the oil price is trading over 6% higher on the day in USD terms. Yet the move in European spot natural gas prices is far larger, with a 46% jump in spot UK prices and a 40% jump in the benchmark TTF contract relevant to the continental European market.

Elsewhere though, we characterise the moves as relatively contained. In FX markets, the US dollar has strengthened, but fairly modestly – it is up 1.2% against EUR, 1.0% against JPY and 0.9% against GBP, for instance. And what was some initial CHF appreciation against EUR earlier in the day has more than unwound at the time of writing.

Equity markets have sold off, but the moves again look contained in the context of the strong gains year-to-date in most major non-US markets, with 1-2½% daily falls at the time of writing. Importantly, there is no indication of safe-haven flows into government bonds: the direction has in fact been the other way, with a small prior rise in government bond yields reinforced by US ISM price data. And even the gold price, markets’ go-to safe-haven asset at time of geopolitical turbulence, is up only 0.5% on the day – leaving it below its late-January peak. For the time being, therefore, it seems that markets assume the conflict will be fairly short-lived and that the worst outcomes will be avoided.

What might the other economic implications be?

The humanitarian and economic consequences, short term and long term, will of course primarily be borne by the people in the region. How widespread and severe these will be remains to be seen. This also applies to the economic implications of the situation for the rest of the world.

Critical in this regard is the extent to which energy infrastructure in the Middle East is impacted. This represents the clearest immediate source of vulnerability for Europe, but also for Asia: Qatar is a key supplier of LNG to China too. In contrast to the aftermath of the US bombing of its nuclear facilities last year, Iran now seems more willing to retaliate by damaging energy infrastructure elsewhere. Indeed, in response to Iranian drone strikes, QatarEnergy has halted LNG production and Saudi Arabia has paused output at one of its oil refineries too.

However, Iran also depends heavily on its own exports of energy, and in particular on the shipping of oil to China via the Strait of Hormuz, as a source of revenue. Its own grain imports use the same route. So it may tread a fine line and continue steer away from inflicting severe damage on others’ energy infrastructure (and from mining the Strait) so as not to invite retaliation in turn. That makes it hard to anticipate whether the Middle East’s energy infrastructure will see little or greater physical damage, and so a short-lived or a prolonged jump in energy prices.

The main economic consequence of higher energy prices would be to boost inflation. In the UK, illustratively, the current level of the oil price would, if maintained, add about 0.2%pts to headline inflation via higher petrol prices; and a sustained 40% shift up in natural gas price futures would boost this by a further 0.7%pts or so, via higher household utility bills. These estimates count only the direct impact for consumers though; in practice, other firms would also seek to recoup some of the higher energy bills they too would face via price rises for their goods and services. In other words, economies in Europe and in Asia could be looking at a sizeable inflationary shock that also weighs on activity. In Europe, this will stir not-so-distant memories of the energy spike and inflation surge that followed the outbreak of the Ukraine war in 2022. Even with weaker GDP prospects, central banks would ultimately have little choice but to tighten policy, having learnt that ‘looking through’ the price shock risks prolonging it.

That said, in a situation as fluid as the current one, the size and duration of the energy impact is not a foregone conclusion, and policymakers will not want to overreact. Moreover, there are three helpful factors to bear in mind. First, Europe has worked hard to diversify its sources of energy imports, which leaves it more flexible than in the past. Second, both Europe and Asia have ramped up renewables output, so fossil fuels play a somewhat diminished role in the energy mix. Third, spring is beginning in the northern Hemisphere. With less demand for energy for heating, there is a window during which Europe and many parts of Asia can ride out higher energy prices somewhat better than at other times of the year.

The situation in the US is somewhat different. After all, unlike most of Europe and Asia, the US is a net energy exporter rather than a net importer. Its own energy producers therefore benefit from higher oil and LNG prices, a situation that boosts the US terms of trade (the ratio of its export to its import prices). This alongside safe-haven flows, seems to be the primary driver of today’s dollar gains. Because of limited interconnectedness of markets, the domestic increases in US spot natural gas and gasoline prices today are much more muted than elsewhere, at about 3% and 4% respectively, at the time of writing. This stands to be a (moderate) negative shock for US consumers, which may come at some political cost to Trump if sustained; it also weakens the case for rate cuts. But on the other side of the ledger is a (larger) income gain for US energy producers.

To sum up, the fluidity of the situation does not allow for firm conclusions. The lack of clearly articulated goals of the US’s actions leaves it fuzzy whether and when these have been achieved. With that, a range of possible long-term outcomes remains. Outside of energy markets, the reaction in financial markets so far looks relatively modest in size. Yet there is a clear risk that the Middle East’s energy infrastructure is damaged in a lasting way, which could impart yet another inflationary shock to net energy importers in Europe and Asia that central banks might need to react to. But the diversification of energy suppliers and in the energy mix leave Europe and Asia in a better place to handle this than in the past, all the more so heading into spring. For now, policymakers are likely to stress vigilance rather than jump to immediate action.