(Bloomberg) -- Traders' hopes for a quick resolution of the conflict in the Middle East are fading.
Last week's wait-and-see stance has changed into something more decisive: markets are pricing in a deeper and longer-lasting supply shock — one that could squeeze growth and revive inflation.
"Investors have had to increase their probability of the worst-case scenario," said Rajeev de Mello, a global macro portfolio manager at Gama Asset Management. "The challenge is the stagflationary nature of the shock."
US Treasury yields are up almost a quarter percentage point since the war in Iran started, while about about $6 trillion in global equity-market value has been wiped out. Traders have pushed back bets on the timing of the Federal Reserve's next interest-rate cut and hikes from the European Central Bank and Bank of England are now priced in.
As crude surged toward $120 a barrel at the start of the day, it became clear the market no longer expects a short confrontation. Brent crude spiked as much as 29% intraday — its biggest swing in almost six years — while measures of equity volatility jumped and trading volumes across Asian exchanges ran well above monthly averages.
The shift gathered pace after President Donald Trump said the US will consider striking areas of Iran that were not previously targets, while the leadership in Tehran vowed not to back down. Trump also said that $100 crude was "a very small price to pay" for "Safety and Peace," undercutting hopes the conflict would be relatively contained.
And feeding into fears of a prolonged war, Iran named the son of the late Ayatollah Ali Khamenei as its new supreme leader, a defiant move by the Islamic Republic.
Key technical levels fell in quick succession in equities, bonds and major currencies as markets opened across time zones on Monday. The latest events lifted the dollar, while energy shares advanced. At one point, Asian equities tumbled about 5.6%, their steepest drop since April.
What Bloomberg Strategists Say...
"Disruption to the Strait of Hormuz creates a far larger potential supply shock that extends beyond oil. Shipping flows more broadly are being disrupted. That is pushing up energy and food costs, lifting inflation and squeezing growth. This stagflationary mix is particularly toxic for markets, as it increases the risk that bonds and equities sell off together."
-Skylar Montgomery Koning, macro strategist. For the full analysis, click here
In bond markets, the yield on 10-year Treasuries was up three basis points at 4.17%, extending the sharpest weekly jump since April. German two-year yields climbed eight basis points to 2.39%, while their UK equivalents soared as much as 30 basis points to 4.17%. Benchmark yields are up by double-digit figures in Australia, New Zealand and South Korea.
Although equities trimmed declines and oil pared gains on the prospect that Group-of-Seven countries will discuss a possible joint release of petroleum from reserves, Monday's market moves were still striking.
"I thought I was going to get some sleep this week, but not anymore," said Matthew Haupt, a hedge fund manager at Wilson Asset Management. "Investors are now bracing for a long winter. The risks are firmly placed to the downside from here with no clear timeline of an end to it."
Bond Swoon
In Japan, one of the first markets to open, some trading floors reported internal communication systems straining under the volume of client inquiries.
There's "heightened tension" on the floor, said Katsuji Azuma, head of equity sales division at Mitsubishi UFJ Morgan Stanley Securities Co.
Bonds also fell across Asia, with benchmark yields climbing by double-digit figures in Australia, New Zealand and South Korea. Europe, which is particularly sensitive to rising energy prices, has been at the heart of the rout, with UK short-dated yields soaring nearly 60 basis points since the start of the war. European blue-chip stocks sank as much as 3.1% on Monday.
READ: Global Bond Selloff Deepens as Oil Jump Stokes Stagflation Fear
"The market is selling off across the board today, regardless of size or style," said Taku Ito, chief portfolio manager at Nissay Asset Management. "If inflation persists while labor demand weakens, a US recession would become inevitable. For equity markets, that would mean the game is up."
The cost of protection against defaults by high-grade firms is also shooting up further and it's now at its highest level since May in both Europe and Asia. Traders are reducing a bullish bet in global credit that amounted to hundreds of billions of dollars.
At the same time, corporate bond returns are taking a hit from inflation fears. The global high-grade credit index has shed almost all of its year-to-date gains — a swift turnaround from gains of 1.6% just over a week ago.
Even before the war began, parts of the credit market were showing signs of strain, as concerns over AI-driven disruption weighed on areas such as private credit and leveraged loans. The surge in energy costs stemming from the Middle East conflict has since broadened those pressures.
Foreign Outflows
Foreign investors pulled $14.2 billion from emerging Asian stocks excluding China last week, the largest withdrawal since at least 2009, according to data compiled by Bloomberg. The selling has centered on semiconductor-heavy South Korea and Taiwan, markets that had become key destination for global AI-related investment.
Volatility gauges tied to Japan's Nikkei 225 and India's NSE Nifty 50 jumped as much as 62% and 23%, respectively, to their highest levels since mid-2024. In South Korea, the slump briefly triggered a trading halt.
"When markets encounter a black swan, everything could fall at the same time," said Anna Wu, a cross-asset investment strategist at Van Eck Associates in Sydney. "That's what we're seeing today — selling across every corner from equities to bonds and currencies, except for oil and dollar."
The MSCI Asia Pacific Index is now within roughly 1% of a technical correction, while the MSCI Emerging Markets Index is nearing the same threshold, underscoring the intensity of the global risk-off shift. The Euro Stoxx 50 Index also neared a correction.
Part of the decline reflects how far markets had run. South Korea and Taiwan had climbed to multi-year highs on insatiable demand for AI chips, leaving valuations stretched and investors sitting on sizable gains. The oil shock has compounded the pressure, highlighting Asia's vulnerability to energy disruptions, particularly in the Middle East.
A significant share of the region's crude and liquefied natural gas imports passes through the Strait of Hormuz, now at the center of the conflict. China, India and Indonesia rank among the world's largest oil importers, while South Korea and Taiwan — reliant on gas-fired power and Gulf supply chains — are especially exposed.
"The current situation is being dominated by emotions such as fear and disbelief," said Hironori Akizawa, a fund manager at Tokio Marine Asset Management. "I am raising cash levels."
Governments across the region are scrambling to cushion the blow. South Korea and Taiwan are weighing market-stabilization measures to stem equity losses and exploring ways to cap domestic fuel costs as energy prices surge.
"Oil is the ignition point," Nigel Green, chief executive officer of financial advisory firm deVere Group, wrote in a note. "Energy security has suddenly become the defining macroeconomic issue again. Investors need to respond decisively now. Stagflation changes the investment environment dramatically."
Read: Yardeni Raises Odds of US Market Meltdown to 35% on Iran War
--With assistance from Gabrielle Ng, Ruth Carson, Marcus Wong, Momoka Yokoyama, Hideyuki Sano, Tasos Vossos and Alice Gledhill.
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