The virtuous loop that has seen America underwrite stability in the Middle East in exchange for Gulf states recycling their dollar revenues into U.S. Treasuries has been broken.

The understanding traces back to 1974, when Henry Kissinger struck one of the most consequential financial deals in modern history. Saudi Arabia would price its oil in dollars and park the surpluses in U.S. assets — Treasuries above all. Other Gulf states followed. In exchange, America provided security guarantees and a stable global order.

The arrangement was elegant in its circularity: Oil consumers paid dollars for energy, those dollars flowed to Riyadh and Abu Dhabi and from there back into Washington’s debt. For 50 years, this petrodollar loop quietly subsidized American borrowing costs and cemented the greenback’s role as the world’s reserve currency.

The U.S.-Israeli war with Iran has fractured this arrangement — at both ends.

Start with the importing side. Following the strike on Iran on Feb. 28, foreign central banks were net sellers of Treasuries for consecutive weeks. Holdings at the Federal Reserve Bank of New York dropped by roughly $82 billion recently to $2.7 trillion, which was the lowest level since 2012.

The 10-year Treasury yield, rather than falling on safe-haven demand as it has in every major recent crisis, climbed from 3.9% at the end of February to above 4.4% within weeks. The rates desk at Bank of America offered a dry summary: "Foreign official sectors are selling U.S. Treasury bonds.”

The mechanism is straightforward. Turkey, India, Thailand and other oil-importing nations are caught in a brutal arithmetic: Oil priced in dollars surged past $100 a barrel at one point while their currencies weakened against the greenback. To limit depreciation — which would push domestic oil prices even higher, forcing either fiscal subsidies or household pain — central banks intervene in currency markets. That requires dollars. The most liquid dollar asset any central bank holds is Treasuries. So they sell.

This is not without precedent. Foreign central banks sold a record $109 billion in Treasuries during the COVID-19 panic of March 2020. But that episode resolved quickly. The Fed deployed dollar swap lines, calm returned and the money flowed back within weeks. The flight-to-quality instinct was temporarily scrambled but structurally intact.

Every other major crisis since — Russia’s invasion of Ukraine, China’s saber-rattling against Taiwan in August 2022, the collapse of Silicon Valley Bank in March 2023 and the Oct. 7, 2023, Hamas attacks on Israel — sent money into Treasuries, not out of them. Yields fell. The playbook worked.

Now consider the exporting side — and why the Iran war is categorically different from all those episodes.

In a normal oil shock, rising prices generate rising revenues for Gulf producers. Petrodollars flow back into dollar-denominated assets, including Treasuries. High oil prices have historically been, paradoxically, supportive of the Treasury market. The shock creates the surplus that generates demand for the bonds.

This time, Gulf producers can’t get their oil out. The Strait of Hormuz closure has stranded their barrels along with everyone else’s.

Gulf states including Kuwait, Iraq, Saudi Arabia and the UAE collectively cut production by at least 10 million barrels per day in March. Saudi Arabia and the UAE can export reduced volumes through alternative pipelines. But those routes handle only about a quarter of normal Strait throughput at full capacity and they are under active Iranian drone and missile threat. Qatar declared force majeure on exports of liquefied natural gas after strikes on its Ras Laffan facility. The Gulf Cooperation Council’s economic model — export hydrocarbons, recycle into global assets — has effectively seized up.

The petrodollar loop requires two moving parts: dollars earned and dollars invested. Both have stopped.

The numbers on the exporting side make this concrete. Kuwait, Saudi Arabia and the UAE had a combined holding of about $300 billion in Treasuries as of January. These countries are now simultaneously earning less oil revenue, spending heavily on air defense and reviewing the investment pledges they made to Washington just months ago.

A Gulf official told the Financial Times that several of the region’s largest economies are examining whether force majeure clauses apply to existing investment commitments, including to the U.S. Gulf sovereign wealth funds, which are big investors in U.S. assets. The direction of travel is now uncertain in a way it has not been in decades.

There is a longer structural story that the war is accelerating rather than creating. The share of Treasuries held by foreign investors had already fallen to around 32%, down from half in the early 2010s. Central banks became net sellers in early 2025. For the first time since 1996, global central banks now hold more gold in aggregate than U.S. government bonds. These were slow-moving trends, easy to dismiss as noise. The Iran war is making them look like signal.

The standard reassurance is that there is no alternative to Treasuries — no other market offers the depth, liquidity and legal infrastructure that central banks require. This remains true. Foreign central banks will not abandon Treasuries wholesale. But "no realistic alternative” and "unquestioned safe haven” are not the same thing — and the Iran war is clarifying the difference.

The flight-to-quality trade has always rested on a political premise: That in a global crisis, the United States is a stabilizer or bystander, not a combatant. But the calculus changes when the U.S. itself is the belligerent; when the conflict is partly America’s war, driving the oil shock, straining Gulf relationships and generating the fiscal pressure that has bond investors worried about U.S. budget deficits. Not completely. Not permanently. But enough.

Kissinger’s 1974 deal held through the Cold War, the Gulf Wars, the financial crisis and a pandemic. It has not survived this. The petrodollar loop was always a political arrangement dressed in financial clothing. Now that the politics have changed, the finance is following.

© The Japan Times