Deescalate to Escalate: The Strait of Hormuz and the Next Phase
Negotiations, force posture, and air defense tell a consistent story: escalation risk remains present even as equity markets price it out.
We are off on another potentially eventful week.
As of 10:00 AM ET, the US has moved from threat to action in the Strait of Hormuz, Tehran remains defiant, and we still see escalation—not détente—as the dominant path. Markets have moved back toward pre‑crisis levels, some of which was mechanical, but despite that price action we remain convicted that this crisis is likely to get worse before it gets noticeably better.
Negotiations: more posturing than progress
Negotiations in Pakistan did not produce a deal. While some commentary from the involved parties hinted at green shoots of optimism, the red lines proved immovable. Much fanfare was made about the “hope” going into this discussion, but the realities of where all sides are anchored didn’t suggest that lasting peace was likely to be restored as a result of time in Islamabad.
Much has been written on the talks, so we won’t rehash every detail here. Instead, a few observations:
• The US struck an upbeat, hopeful tone on future negotiations. This needed to happen to keep the ceasefire framework alive and leave the door open for future diplomacy.
• Iran labeled US demands “maximalist,” even though they were largely unchanged from prior rounds. Tehran’s information strategy continues to oscillate between victim and aggressor; this is its victim card.
• Israeli reporting suggests the talks went less well than politicians are touting. Both sides remain very far apart on the Strait of Hormuz and Iran’s nuclear program or ambitions, and Iran’s support of deemed terrorist proxies remains a core sticking point.
• Numerous outlets have described the talks as having “wide gaps” and “deep divisions.”
• Al Jazeera and The Guardian note that Iran is sticking firmly to its preconditions.
• Several think tanks have summarized the talks as being more about posturing than compromise and as a way for Iran to buy time and retain leverage.
Diplomacy remains the preferred path. However, given that both sides are rationally dug into their positions, further military conflict still reads as the high‑probability outcome rather than a durable deal before further hostilities.
We expect escalation to happen sooner than most appreciate.
Deescalate to escalate
The US strategy has been to strike hard, then pause. “Escalate to deescalate” has been bandied about multiple times by multiple officials. Flipped on its head—“deescalate to escalate”—the picture of how the US is handling the conflict reads more clearly.
Twice now, the president has materially deescalated after significantly escalating threats, only to come back with further military action. The aim appears to be to minimize total military action while doing “just enough” for Iran to concede to US demands. When you consider that the US has largely avoided Strait‑of‑Hormuz‑focused Iranian military targets, the idea that they are “running out of targets” is misleading. The US may have exhausted useful targets for that wave of the campaign, not run out of things to shoot at. That is an important distinction when considering a deescalate‑to‑escalate approach.
Iran, in turn, has absorbed significant damage and leadership losses. However, Iran remains functional. They are not “obliterated,” and their missile reserves are unlikely “depleted.” To the contrary, Iran likely retains roughly half of its missile magazine, thousands of Shahed drones, and at least some domestic weapons manufacturing capability. They are still in this fight, but they are degraded and have minimal time to make repairs and rearm ahead of any renewed engagement.
Because US objectives have not been met (no Iranian nukes, no Iranian control of the Strait of Hormuz), and diplomacy did not provide the desired offramp, further kinetic action reads as the highest‑probability event and one that likely begins sooner rather than later. On point:
• US C‑17 flights carrying supplies and equipment have remained steady into the Middle East, with some reports of levels not seen since the build‑up to the conflict.
• A‑10 aircraft have received a modification that dramatically increases their loiter time, important for CAS in a contested environment like the Strait of Hormuz.
• US warships have now enacted a blockade of the Strait of Hormuz.
• Some reporting suggests China and Russia are providing additional arms to Iran.
• There has been rapid deployment of Ukrainian‑made interceptor drones to several Gulf states under multi‑year arms deals, and some of these interceptors have already been used in the Iran conflict.
Layered defense and interceptors
The point regarding Ukrainian drone interceptor systems is an important one. The US attacking Iran again is well within Washington’s toolkit; the problem is Iran’s retaliation.
If the US uses force to open the Strait of Hormuz, Iran will likely retaliate and do so aggressively. At minimum, Tehran could respond in a way that has a high probability of being negative for oil prices. The current pause has allowed time to rearm and prepare to absorb Iran’s military retort. Those Ukrainian drone interceptors are a major boon to absorbing Iran’s response and limiting it to what is likely viewed as acceptable levels of damage.
Gulf states have been heavily dependent on Patriot or THAAD systems to stop drones and various missiles. Those rounds cost millions of dollars each, take a long time to manufacture, and are not plentiful. Ukrainian drone interceptors cost orders of magnitude less per unit, and Ukraine is ramping production to build very large numbers per day, with many already completed and stored for arms deals and domestic needs. These interceptors create a layered defense: Patriot/THAAD for missiles; Ukrainian interceptors for Iranian drones. If Iran’s drone magazine is significantly larger than its remaining missile capacity, having thousands of cheap and effective interceptors on hand at any given time materially degrades one of Iran’s primary mechanisms of projecting force.
Gulf allies can conserve their US‑provided, very expensive missile defense systems for more advanced threats. Said plainly, a high‑confidence, well‑stocked drone interceptor inventory is a major game changer for the US and Gulf partners. It increases their tolerance for escalation by reducing the expected damage from Iran’s most scalable retaliation tool.
Two weeks buys time to move in a whole lot of interceptors. Interceptors are an example that personifies a larger theme: be able to effectively absorb the retaliation, take the data you get from that retaliation, and return on active Iranian sites as soon as possible. It wouldn’t be surprising if we hear more about Ukrainian‑designed interceptor systems in the near future.
Where we go now
Our base case remains further escalation in the conflict. Developments that would materially change this base case include events such as:
• Iran conceding on nuclear enrichment for at least 20 years.
• Iran formally relinquishing control of the Strait of Hormuz.
• Iran agreeing to no longer sponsor proxies or terrorism, both in the Middle East and globally.
• China, or a set of Iran‑aligned or adjacent countries, pressuring Iran into opening the Strait of Hormuz.
• China or Russia convincing Iran to give up its nuclear program while offering nuclear defense pacts, providing a shield over Iran similar to NATO.
All of this is possible. Relative to what appears to be getting teed up by the US right now, taking such a deal would likely be the wiser decision for Iran. There is a world in which Tehran agrees to most of those points and its society is better off for decades to come. That is a future to favor, but not one we read as high probability unless the build‑up of US firepower and global pressure leaves Iran with nowhere to hide and, to save face, they capitulate.
One ray of light for this scenario is Gulf allies obtaining layered defense systems. Iran likely realizes that one of its primary modes of projecting power could have materially muted impact. In Tehran’s shoes, that might shift some of the calculus.
Based on available information, it reads more probable that the US begins limited tactical strikes aimed at establishing freedom of navigation in the Strait of Hormuz, rather than a repeat of the earlier high‑tempo bombing campaigns. The Iranian response would likely be aimed at Gulf energy infrastructure. If enough damage is done by the US, Iran may capitulate. The reason this phase is more dangerous is that the US would now be directly attacking one of Iran’s crown jewels. Iran will be forced to demonstrate some measure of strength or risk losing leverage. Iran is wounded but not decimated, and its resolve should not be underestimated.
This may well come before the end of the official ceasefire deadline, because the US has political and strategic cover. Technically, Iran has never fully abided by the terms the US laid out for a mutual ceasefire. Hostilities are calmed for the moment, but the deal doesn’t really exist beyond its spirit or usefulness to Washington. The longer we remain in a higher‑oil‑prices‑for‑longer regime, the worse it is for the global economy into Q3 and Q4. Signs of demand destruction are already occurring. Gasoline prices are high and rising in a mid‑term election year. The president has many reasons to get this over with if it must occur.
For markets
From a market perspective, this piece reads notably contrarian versus the index‑level equity rally back to, or above, pre‑conflict levels.
That rally reads as exuberant. Market positioning and various mechanical triggers likely played a notable role in the quick thrust higher over the last week. That then pulled in momentum chasing, FOMO/FOMU, and a sentiment lift as the tape tells the crowd the worst is behind us. That may prove true, and if so, it would be a welcome outcome.
However, oil markets are telling a different story. Some of the better bank and commodity analysis on this conflict does not suggest we are heading to an “all clear” scenario imminently. Multiple countries are receiving their final shipment of jet fuel or other refined products this week. Global supply is materially snarled; jet fuel is just one simple example. The real impact of the oil shock may be only now playing out, which runs contrary to headline-driven equity price movement over the last week.
Competing regimes emerge:
• Equities: bombs not flying → ceasefire good → oil prices down a bit (then back up) → Iran or the US will soon capitulate → the worst is behind us and things will free up shortly and forward looking economic impact is navigable.
• Oil: bombs not flying → SoH only moderately opening → shortages are real → risk premium remains while the fate of the SoH, global supply, and any further conflict damage is uncertain.
This analysis tends to agree more with liquid gold than with stocks. Equities price the future but may be mistaking a mechanically fueled recovery for a sign that the economic impact of the conflict is either behind us or muted. That is possibly true, but we already see a high probability of renewed inflationary pressure into Q3 from this shock.
This brings us to a final market‑related point for this update. We have put some weight on the notion that equity investors do not quite know how to read Trump and may draw too heavily on their lived experience since 2020 and the prior administration. To President Biden’s credit, if he said something was going to happen, it typically did—they were on narrative collectively - which means the narrative was very clear to follow.
Trump has, in this crisis, messaged escalation hard only to pivot at the last minute. We went from “obliterate a civilization” to “I’m hopeful for talks” at a pace that can cause whiplash. But that is his style. The more he is selling you on something, the less likely it is to happen in many cases, especially when what we are hearing doesn’t logically align with other datapoints. Trump is saying what the market wants to hear, and the market appears to be listening.
Unless Iran is willing to negotiate further or meet US demands—which still reads as unlikely—we will probably hear market‑soothing leaks and talk of a deal until the US engages. Stylistically, the US has tended to threaten with big escalation and act with smaller‑scale operations. Narrative reset: Iran never abided by the ceasefire, using the already‑established cover, and the next phase begins. This would likely catch markets off guard as the narrative once again shifts materially.
This may bring Iran back to the table quickly. But if Tehran returns to talks after a successful retaliatory strike, it negotiates from a much stronger position than folding on or before US engagement. Markets may react negatively to US strikes, but the Iranian response reads as what to watch should this come to pass. If Iran’s retaliation is muted by the US and allies, a path to a deal reads as more likely. If the strikes from Iran are effective, we would expect a materially negative market reaction as energy prices would likely rise substantially and Iran would be emboldened to continue course and speed.
Like any base case, this one can be undone by any number of developments. Over the long term, we don’t think the Strait of Hormuz will be as consequential as it feels today: countries will pivot to overland pipelines, US and Venezuelan output can increase, and refinery capacity will come online globally. However, those are all years away from being able to fully replace current lost supply. That future is actually quite bullish and something to look forward to, but here and now, the energy markets, unsuccessful negotiations, and military buildup suggest we are still some distance from that world.
Disclaimer: This publication is for informational and educational purposes only and reflects the views of the author at the time of writing. It does not constitute investment, financial, legal, or tax advice, and it is not a recommendation or solicitation to buy or sell any security, strategy, or instrument. Any securities, instruments, or strategies mentioned are discussed solely as examples in the context of macroeconomic and geopolitical analysis. You are solely responsible for your own investment decisions and should conduct your own research and consult with a qualified financial, legal, and tax adviser before making any investment or other decisions. Past performance, scenarios, or views are not indicative of future results, and all forecasts are inherently uncertain.