Late last week, the escalating conflict between Israel and Iran took an unusual turn. Friday morning, social media and other news sources reported that Israel had undertaken a strike against several Iranian cities (including Isfahan, which is home to several military bases and Iran’s nuclear research complex) in retaliation against Iran’s recent missile and drone attack on Israel. Iran’s recent strike was triggered by Israel targeting Iran’s consular building, attached to its Syrian embassy, killing several senior members of its Republican Guard.
As one would expect, the news triggered an immediate response in the global financial and commodity markets. Equity prices and futures dropped sharply, US treasury rates fell, and the price of oil and other precious metals rose sharply as the markets repriced the risk of further escalation in the region. In short, investors shifted into “safety” mode.
As is their custom, Israel’s military made no comments about the attack, neither confirming nor denying the event.
However, a very unexpected thing happened as the situation unfolded. Iran’s state-run news and other government agencies came out and said the attack was a very limited drone strike, its air defence system had neutralised the threat, and there was no resulting damage. Moreover, Iran stated it would not respond to Israel’s strike, in effect playing down the entire incident and de-escalating the situation.
Due to Iran's response, the fear of further escalation and direct conflict between the two nations steadily faded, and markets recovered. Equity markets rebounded, and commodity markets pulled back. In fact, at the time of the market opening in the US Friday morning, crude oil prices had pulled back so far that they actually opened slightly down against the closing price from Thursday.
Friday’s events can only be described as surprising. Iran had previously stated that any attack by Israel, irrespective of size, would be met with an immediate and powerful counterstrike. However, it is clear that despite Israel's limited response, Iran sought to de-escalate the situation. It seems that several factors most likely drove Israel's response. First, it wanted to reassert its “deterrence” strategy and respond to Iran’s unprecedented direct strike on Israel. Second, Israel wanted to continue to draw attention away from the Gaza crisis and have the international community refocused on the growing tensions with Iran. Conversely, Iran appears unwilling to play this game and wants the attention to be shifted back to the Gaza crisis, which was clearly causing tension between Israel and its allies.
Israel’s allies were pushing hard not to respond to Iran's strike and were caught off guard by its response. Moreover, despite the requests of allies, particularly the United States, Israel appears undeterred in its expansion of its military activities in Gaza and attacking southern Gaza. This will surely make the current humanitarian crisis worse and continue to negatively impact Israel’s relationship both with its neighbours and the international community. However, with the US Congress's recent passage of $26 billion in additional military aid – Prime Minister Netanyahu must be breathing easier. Sooner or later, it would be a reasonable assumption that Israel will turn its attention to Northern Israel/Southern Lebanon to deal with the Hizbollah threat.
While it appears the region has avoided escalation for the moment, the situation remains unstable, and the risk of conflict remains uncomfortably high. Both nations have attacked each other for years through the use of proxies (Hizbollah and Israel have been trading fire now for several months); however, the recent events have altered the old status quo – they have now directly attacked one another, and there is no going back. As a consequence (and as seen from the markets' reaction when they believed the tensions were once again escalating), commodity prices will react sharply to any news that points to a resumption in the escalation cycle. Any whiff of an increase in tensions will reflexively send commodities markets sharply higher, and only afterwards will they look to assess the situation in more detail. As a consequence, we can expect continued volatility as the market reacts to any news coming from the region. For the foreseeable future, market pricing will not only be based solely upon traditional fundamental market analysis (i.e., supply versus demand) but also upon its assessment of geopolitical risk levels and market psychology.
