Why is it so difficult for the US and Iran to stop the war?

Morning FX

This past weekend, the US-Iran war, which has lasted nearly a month, officially entered its fifth week, surpassing the four-week timeframe initially predicted by Trump at the start of the conflict. At present, both sides are confronting each other over an almost impossible agreement,and amid this war of attrition, Iran has become the side more eager to maintain the status quo.

Image: International oil prices are still striving for new highs

The price the world pays each day is not limited to the surge in oil prices. Iran's demonstrated potential for disrupting energy choke points and infrastructure casts a shadow over investment in the Middle East,further deepening the long-term risks for energy prices.

1. An Almost Impossible Agreement

Trump claims the negotiations with Iran are far from formal diplomatic contact. Through mediation by Pakistan as a third party, both sides have put forward their respective demands for a ceasefire, but it’s as if they’re talking past each other.

US side: (1) Dismantle Iran’s nuclear capability, transfer the 450kg inventory of 60% high-enriched uranium, dismantle nuclear facilities at Natanz, Isfahan, and Fordow, etc. (2) Cease support for regional proxies, limit the range and number of ballistic missiles (3) Ensure the Strait of Hormuz remains open.

Iranian side: Iran to receive all compensations, lift all sanctions, the US to stop interfering in Iran’s internal affairs. Meanwhile, Iran continues to administer the Strait of Hormuz, rather than it being labeled a “free maritime zone.”

The US demands are essentially the prewar nuclear agreement plus access to Hormuz. Matters that couldn’t be resolved at the negotiating table are even less likely to be agreed upon now that the situation favors Iran. As for Iran’s demands, they take on the posture of a victorious nation, which is bound to differ greatly from Trump’s expectations.

Image: A major decisive battle in the US-Iran war may be approaching

Meanwhile, US amphibious assault forces are set to arrive in the Middle East. With “delaying tactics,” the likelihood of an intensified strike against Iran is increasing.

2. Unpredictable Battlefield and Long-term Consequences

The easing sentiment only lasted one day, and international oil prices are surging towards new highs, while stocks, bonds, non-USD currencies, and commodities (other than crude oil) are falling across almost all categories.

Image: The fear index is positively correlated with the US dollar index

But will the market’s reaction function change? Especially whether the rationale for the US dollar index and US interest rates rising due to the war is solid. For instance, some argue that if the war drags on, countries friendly with Iran such as China might receive “priority access,” which would shake the foundation of the “petrodollar system,” directly undermining the dollar’s status and causing the US dollar index to fall.

Additionally,research institute Citrini Research believes that rising oil prices won’t push the Federal Reserve to raise rates, but could actually increase the likelihood of distant rate cuts.

The current environment is completely different from 2022. Back then, the policy rate was at 0%, inflation was close to 5%, and the real rate was highly negative, leaving the Fed no choice but to sharply hike rates to cool off demand-driven inflation resulting from fiscal stimulus; but now the real rate is positive and already in restrictive territory, further hikes can’t affect oil supply and would only cause recession. Economic weakness caused by rising oil prices would in turn hasten a Fed rate cut.

3. Summary

(1) There’s little sign of progress in US-Iran peace talks, there’s a risk of a major decisive battle, and markets are back in panic mode.

(2) Trump’s unreliability coupled with the Fed’s dilemma amid rising oil prices—if the war drags on, the logic for the USD index and US interest rates may undergo a shift.