26.05.202610:31 Forex Analysis & Reviews: Market not indulging illusions

Holidays prevented a false rally in the S&P 500. US President Donald Trump's comments about progress in talks with Iran could have sparked another wave of stock buying. Instead, US warships fired on Iranian boats laying mines in the Strait of Hormuz, followed by reciprocal strikes on military targets — actions that look more like escalation than de-escalation. That is unlikely to suit the broad equity market.

At first glance, the S&P 500 appears to be ignoring the US–Iran confrontation. The rally in US equities rests on impressive corporate earnings and economic strength, while geopolitics has receded to the background. However, the longer the Middle East conflict drags on, the more its effects are felt in the equity market.

Treasury yields and oil price dynamics

Geopolitics primarily affects the S&P 500 via the bond market. A rally in Brent has lifted inflation expectations and pushed Treasury yields higher. In theory, that should increase corporates' financing costs, squeeze profits, and trigger a pullback in the broad index. In practice, the decisive factor will be issuers' ability to source more funding elsewhere — and here artificial intelligence is helping materially.

Valuations tell a different story. As Treasury yields rise, equities become more expensive on a risk-adjusted basis. The equity risk premium is currently close to zero, roughly in line with Treasury yields. Treasuries are viewed as the safest assets and equities as risky, so a risk premium should exist; its absence raises the probability of an S&P 500 bubble.

Equity risk premium dynamics

The fact that the S&P 500 is largely ignoring geopolitics could imply limited upside if a lasting peace is reached in the Middle East. In many markets, the reaction would be a complete 180-degree reversal, but not necessarily in equities.

The main beneficiaries of the US–Iran standoff have been oil and the US dollar; the losers have been Treasuries and gold. If the peace returns, Brent and the greenback would likely face a wave of selling, Treasury yields would collapse, and gold would regain demand. The S&P 500 would probably rise too, but any rally is likely to be modest — the market has already priced in expectations of conflict resolution, and much of the move would be a replay of that fact.

Technically, it is worth watching for reversal patterns on the daily S&P 500 chart — 1-2-3 formations and a potential double top. Under that scenario, a correction would be likely. Conversely, if bulls can hold prices above the 7,460 pivot level, that would support further long accumulation.