Image © Adobe Stock

Investors should monitor Israel's rhetoric around any Iranian involvement in the recent Hamas terrorist attacks over the coming days and weeks, as this would signal a meaningful deterioration in geopolitics is underway.

This is according to U.S. bank Wells Fargo, where strategists expect Dollar and Treasury outperformance to track rising oil prices in response to any potential Israeli retaliation involving Iran.

"Direct Israel-Iran military conflict or the military involvement of other influential actors such as Saudi Arabia and Qatar—would shift the global geopolitical climate in an even less favourable direction," says Brendan McKenna, International Economist at Wells Fargo Economics.

"While the likelihood of an escalation to a regional conflict is outside our scope, broader military conflict in the Middle East would likely result in reduced oil supply and a spike in crude prices," he adds.

Oil prices and the Dollar jumped on Monday morning as markets reacted to weekend news of the massive terrorist attacks conducted by Hamas. However, the market reaction proved relatively contained with gains being given back as markets assessed the relative containment of the conflict from a geopolitical perspective.

But the market reaction to an Israeli response that targets Iran - a "vital" funder of Hamas - would be expected to be more lasting and severe, according to Wells Fargo.

"As evidenced during the initial phases of the Russia-Ukraine conflict, rising oil and natural gas prices can inflict severe damage on select economies around the world, particularly G10 countries and key emerging market nations that contribute materially to global growth, such as China and India," says McKenna.

In the coming days and weeks, Wells Fargo will be watching for evidence and/or rhetoric that implicates Iran as a hostile actor in the attack on Israel.

Israel has been careful to limit speculation as to its intelligence regarding any Iranian involvement; "Iran is a major player but we can’t yet say if it was involved in the planning or training," said R Adm Daniel Hagari, a spokesperson for the Israel Defence Forces.

Investors should now watch how the messages coming out of Israel regarding Iran shift over the coming days and weeks.

"Should proof be presented that Iran knew about, coordinated or outright supported Hamas' aggressions by supplying resources, Israel's military offensive could extend beyond Gaza and toward Tehran," says McKenna.

He warns that a direct Israel-Iran conflict would significantly worsen the geopolitical backdrop and have direct economic implications around the world via higher oil prices and deteriorating sentiment.

"In the event of regional escalation, safe-haven assets such as the U.S. dollar and U.S. Treasuries would likely outperform, and we would adjust our forecasts to reflect more greenback strength and more risk-sensitive currency depreciation at least through the end of this year," he says.