No Deflationary Impulse from War
There is no deflation impulse ever with wars. That’s not a thing. And besides, you can have what is called a knee-jerk reaction where people are stuck with a 60-40 strategy in their portfolio, and then they see the risk in their stocks because of the situation going on in Iran, and they knee-jerk buy bonds.
War and Debt Are a Bad Mix
But wars are never, ever, ever positive for countries that are largely indebted and have a large external debt. That’s also not a good thing.
Market Crashes Are Not Deflation
Besides, you can have markets crashing, like in 1973–74, for example, and it has nothing to do with deflation. If you want deflation, you can get it by cutting government expenses.
How Deflation Actually Happens
That’s what McCullough did after the Civil War: cut war expenses, balance the budget, or even run a surplus and repay debt. Then you’re going to have massive deflation.
Asset Price Declines vs Real Deflation
So you can have prices moving down in certain financial assets, like in 1973–74. It’s certainly not deflation. You can have bonds rallying, knee-jerk rallying, because investors don’t know what else to do.
Monetization and Inflation Dynamics
But given that the Fed is monetizing the deficit, as Nassim Taleb explained, a shock in commodity prices is a type of inflation shock you cannot control with a central bank. There is no deflation scenario here with rising commodity prices.
Limits to Energy Price Upside
Although I think that the room for higher oil and gas prices is overestimated, because for a variety of reasons, I’m not entirely sure that the US has calculated the supplies it needs for this war. So I’m not entirely sure it can sustain a very long war.
U.S. Constraints in a Prolonged War
There are logistics issues, manufacturing issues—not because they would not like to have a long and winning war with Iran—but the financial position is not there, and the logistics situation and weaponry situation are not there either. The rare-earths situation is not there. Let’s be frank about that.
Strategy: Short War vs Long War
So maybe the idea was decapitation—go quickly into a regime change, and that’s it. If the war is protracted, I’m not sure that the US can afford a prolonged war, neither financially nor militarily.
European Positioning and Geopolitics
Now, the next thing that is important to realize—and also given that Europeans have been very wary about the moves from Mr. Donald Trump over Greenland—I very much think they are interested in providing support, either on the bond side or military, or only after US is seriously weakened first. In fact, if the US is weakened, it is probably in their interest.
Bond Market Structure Problems
There is also the consideration of the bond market. So Mr. Gundlach and Mr. Druckenmiller are very concerned about the fiscal situation. They are both short the USD and UST.
Short-End Issuance and Repo Stress
The problem is that there are not that many bonds issued on the long end, so most of the issuance is on the short end. This creates repo spike pressures because of absorption issues with hedge funds, and it also creates the need to monetize the debt and the deficit.
Central Bank Constraints and Market Signals
And one of these is just the logical consequence of having too much issuance on the short end: the central bank has to monetize the deficit. So in that context, there can be a fear that the long end of the bond market does not react and it seems like, “oh, we have deflation.” You have knee-jerk moves, and you don’t have a very active market. You also have central bank intervention before they even start expanding the balance sheet. They were swapping the long end for the short end.
Historical Precedent: Bond Market Collapse
Now, can it last indefinitely? Well, if you look at precedents in history, if you look at Robert Pitt’s situation during the Napoleonic War, he issued, issued, and issued, and eventually the bond market completely collapsed in 1815 in the UK.
Final Thought: Shorting U.S. Bonds
So this is not— The collapse of the bond market is absolutely not off the table at this point. In fact, it’s kind of interesting because if people rally bonds right now, given the situation, it might be another interesting entry point to short US government bonds, especially if you think that this conflict is not going to end in the next few days.