The Contagion in Supply Chains

Nor does the problem stop with oil. A significant share of global trade in liquefied natural gas, sulfur and fertilizers also passes through the Strait of Hormuz. Disruptions have also affected helium, which is essential for healthcare and semiconductor manufacturing. Closing the strait therefore raises far more than the price of a single commodity. It gradually ripples through multiple supply chains.

Households will feel the impact of higher fuel prices almost immediately. Fertilizer prices, by contrast, take longer to feed through the economy. Farmers first face higher costs, crop yields may then decline and only later does the effect appear in food prices. The Food and Agriculture Organization of the United Nations (FAO) has warned that the current fertilizer shortage could reduce future harvests and constrain food supplies in the second half of this year and into 2027.

The inflationary shock is therefore unlikely to peak only once. Successive waves could emerge even if the situation in the Persian Gulf stabilizes in the meantime. Central banks may then struggle to convince the public that this is still the same temporary supply shock.

Nor is the energy squeeze occurring in isolation. It is being compounded by rising memory chip prices as manufacturers shift more production capacity toward high-performance memory for servers and data centers. That leaves less conventional memory on the market, pushing prices higher.

With each passing month, the risk grows that higher inflation will become more than a temporary episode. Companies will seek to pass rising costs on to customers, while workers will demand higher wages to offset the increased cost of living. That is precisely the point at which a one-off supply disruption can evolve into a much more persistent inflation problem.

The Market Is Not Waiting

The market will not wait for central banks to act. Inflation expectations are already rising and, with them, yields on long-term government bonds. Regardless of how policymakers respond, investors will demand higher returns if they believe inflation will continue to erode the value of their investments.

The next challenge is that interest rates are far higher than they were when governments grew accustomed to borrowing at almost no cost. At the same time, public debt is substantially higher than it was five years ago.

Bond yields therefore do not need to wait for an official central bank decision. It is enough for investors to lose confidence that inflation will ease quickly. Governments would then be forced to issue new debt at higher interest rates while refinancing bonds sold when borrowing costs were close to zero. As debt-servicing costs rise, they crowd out other areas of public spending. The more governments spend on interest payments, the less they have available for everything else.

That is why a shift in monetary policy may prove more damaging to financial markets than higher oil prices alone. More expensive borrowing reduces bond prices, raises financing costs for businesses and weighs on equities. Companies with high valuations based on profits expected many years into the future are especially vulnerable. Markets can adapt to expensive energy. They react far more sharply when they conclude that elevated interest rates are not merely a temporary phase.

This is where the greatest risk lies. The expectation that 2026 would be dominated by debate over whether the Federal Reserve would cut interest rates once or twice is unlikely to materialize. Kevin Warsh's nomination was intended to accelerate that process. Donald Trump repeatedly criticized his predecessor, Jerome Powell, for moving too slowly to cut rates.

Lower borrowing costs were meant to support Trump's tariff-based trade policy while also weakening the dollar. That strategy is no longer viable. The Federal Reserve has left interest rates unchanged, maintaining them in the 3.5%–3.75% range since the start of the year. One thing is becoming increasingly clear: the scope for rate cuts this year has all but disappeared.

Some central banks have moved in the opposite direction by raising interest rates. The European Central Bank (ECB) took that step in June. The Bank of Japan followed, as did the Bank of Korea in July. Monetary policy has therefore evolved in precisely the opposite direction from what investors expected at the beginning of the year. Instead of debating how quickly rates will fall, markets are now asking which central bank will be next to raise them.

The Bond Market Has the Last Word

Ultimately, the bond market will determine the true impact of the current inflation shock. In particular, the long end of the yield curve will reveal whether investors still believe inflation will come back under control or whether they are already demanding higher returns on long-term government debt. Central banks may leave policy rates unchanged, but if yields on 10-year and 30-year government bonds continue to climb, financial conditions will tighten even without any official action.

The longer the conflict drags on and inflation remains elevated, the more expensive it becomes for states to finance themselves. Rising borrowing costs quickly expose the limits of fiscal policy. That reality is already evident in the United States, Japan and France.

Japan is adjusting to the highest bond yields in decades. In the United States, 10-year Treasury yields have climbed back above 4.5%, while France is approaching the point at which it must pay around 4% to borrow for 10 years for the first time in many years. The bond market may therefore exert growing pressure for a political resolution to these conflicts. As the war continues, it is placing an increasingly direct burden on public finances.

At the same time, higher bond yields offer investors a more attractive alternative to equities. If government bonds provide returns of 4% or 5%, some capital no longer needs to seek higher returns in the stock market. In the end, equity markets may not bring down the prices of oil, natural gas or fertilizers. Instead, they could come under pressure from the bond market, which is the first to price in persistent inflation and a prolonged period of tighter monetary policy. The bond market will determine whether equities can maintain their current resilience or whether higher borrowing costs eventually catch up with them.