The White House has sent shockwaves through the Treasury market this morning. President Trump is demanding a multibillion-dollar supplemental appropriation from Congress to fund a potential military confrontation with Iran. This fiscal bombshell comes at a time when the Republican party is deeply fractured, with deficit hawks balking at the prospect of another Middle Eastern entanglement that could send the national debt spiralling.
Let us be clear about what this means for the markets. The 10-year gilt yield is already twitching. A sudden surge in government borrowing to finance a war would flood the bond market with supply. Investors, already skittish about a looming recession, will demand higher yields to absorb the risk. That is a recipe for a debt spiral. The dollar may strengthen on geopolitical uncertainty, but capital flight from risk assets is a foregone conclusion.
The President's demand is a classic case of fiscal impulsiveness dressed up as national security. He wants a blank cheque for a conflict that could easily escalate into a regional conflagration. The estimated cost of a sustained campaign against Iran runs into the hundreds of billions, according to Pentagon projections. That is money that will have to be borrowed, printed, or taxed. Given the current political climate, borrowing is the only realistic option. The Federal Reserve will be forced to accommodate this fiscal expansion, further blurring the line between monetary and fiscal policy.
Why now? The President is clearly trying to force the hand of his own party. The Republican base is hawkish on Iran, but the fiscal conservatives in the House Freedom Caucus are screaming about the national debt. They remember the 2003 Iraq War, which cost over $2 trillion and was paid for with borrowed money. That conflict bloated the national debt and left the US with a decade of low growth. Now, with the debt already exceeding $23 trillion, another war could be the straw that breaks the camel's back.
The political calculus is brutal. Trump is betting that the patriotic fervour of a military conflict will drown out the fiscal complaints. But the bond market does not care about patriotism. It cares about creditworthiness. If this demand goes through, expect to see US credit default swaps spike. The rating agencies will be watching. A downgrade of US sovereign debt is no longer unthinkable.
The European reaction is telling. German bund yields are dipping as capital seeks safety. The euro is under pressure. This is not just an American problem. A US-Iran war would disrupt oil supplies, sending energy prices soaring and inflation expectations through the roof. Central bankers worldwide will have to tighten monetary policy just as growth is slowing. It is a stagflation shock in the making.
The irony is that the President campaigned on ending endless wars and bringing fiscal sanity to Washington. Now he is demanding war funding that would make the Obama stimulus look like pocket change. The cognitive dissonance is staggering.
What happens next? The Senate will have to approve the appropriation. Mitch McConnell is in a tight spot. He needs to keep his caucus united, but the deficit hawks are restless. Expect a series of backroom deals and arm-twisting. The markets will be pricing in the outcome. If the bill passes, expect a sharp sell-off in Treasuries. If it fails, the dollar will take a hit as confidence in US governance falters.
The bottom line is this: war is expensive and the bill always comes due. This time, the markets are not in a forgiving mood. The era of cheap borrowing is over. The Fed's balance sheet is already bloated. Adding war debt to the pile is a dangerous game. Investors should brace for volatility and perhaps hedge with gold. The safe haven trade is back in fashion.
That is the cold, hard truth of it. The President wants a war. The bond market may have other plans.
