Macro Musings:
- The oil price shock is expected to offset much of the consumer growth effects from the OBBBA in Q1 2026, with higher gas prices negating the spending boost from larger tax refunds.
- Though the US consumer is far less sensitive to oil shocks today, there is less capacity to absorb higher energy prices given the already low personal savings rate and lower equity prices that will negatively impact wealth effect spending. “How high and for how long” the impact is on oil prices is the key unknown, but the war in Iran presents a significant headwind to growth in an economy already running solely on AI optimism/infrastructure spending.
- There is little to suggest a near-term recovery in the labor market. After a year of no job growth, the immigration picture remains the same, and we see no indication labor force participation rates will rise, both of which suppress labor supply and subsequent jobs growth. The positive momentum from small businesses that emerged last year has already begun to reverse, with NFIB hiring plans showing renewed weakness in labor demand. The added headwinds to growth support unemployment approaching 5%.
- Oil shocks have an acute impact on inflation, but the effects will quickly fade. So long as inflation expectations are anchored, the passthrough into core prices will be minimal (absent intervention gov’t policies like price controls, subsidies or stimulus checks). Overall, the risks to growth outweigh risks to underlying inflation.
Market Thoughts:
- A perfect storm hit the markets over the last month – the largest jump in monthly oil prices in recent history, following a period of compressed vol and concentrated positioning in rate cut expressions along with dollar diversification trades (like EM equities and precious metals), resulting in most asset classes (minus Oil, DXY) seeing correlation rise as returns went negative.
- Global rates markets displayed a much stronger magnetic pull on US rates in this latest sell-off, largely felt in the front-end via higher breakevens. G3 inflation expectations had a notable jump post the start of the war with Iran, dragging up US rates too.
- Decomposing the shift higher in rates across the Treasury curve, the front-end was most impacted by a repricing of breakeven inflation (BEI) whereas the longer end was driven by fiscal concerns as real rates also climbed. As near-term inflation pricing shifted, it led to a major repricing of Fed rate expectations.
- Unless oil prices rise to $120 or higher, and remain there for months, we argue that the rates market has priced out 2026 rate cuts too fast. And with Treasuries now a positive carry, they now are one of the highest quality trades given the issues that still linger in private credit and a pre-war world that was still fragile.
- Any sort of resolution to the conflict, with reopening of the Strait, would be short-term bullish for risk assets. We would use any such rally to take profits/build cash and move into MBS & USTs.
Fed and Rates View:
- Given the high uncertainty, a scenario-based framework is the most appropriate lens to analyze what could be the various paths that Fed policy embarks on next. We emphasize that the neutral rate for the US is still around roughly 3%, and that current dynamics (short-term inflation concerns vs. long-term growth shock) suggest rate cuts are delayed, rather than fully derailed.
- In the best-case, a quick resolution to the war and the reopening of the Strait of Hormuz would see oil prices drift down toward pre-conflict levels ($50-$75). If the labor market shows signs of stabilizing, it could delay or reduce the total amount of rate cuts.
- Our base case is more pessimistic and assumes a longer conflict (a series of ceasefires/negotiations) with oil hovering in the $75-$100 range. This would likely offset some or most of the Q1 boost from OBBBA related tax refunds, softening the growth outlook and making unemployment risks outweigh inflation risks. As long as inflation expectations remain anchored with oil below $100, the Fed should see past the oil driven supply shock and begin normalizing policy, thus we keep our three cuts, starting in July.
- In the worst-case, oil prices hold above $100 and become a significant headwind, tightening financial conditions as equities reprice to weaker earnings. Oil this high is a stagflationary shock that could quickly evolve into a recession risk, particularly if private credit markets continue to deteriorate in the background.
US Policy Updates:
- Wars generally favor the incumbent, however the situation in Iran is proving to be largely unpopular (as seen by the latest polling number results) with prediction markets increasingly expecting a mid-terms Democrat sweep (take control of the House & Senate).
Special Topic – Sending out a SoH (reopening plea)…:
- We explore several geopolitical, commodity and market scenarios unpacking the broad macro implications of the Middle East war.
- The Strait of Hormuz is an important chokepoint, and its closure has proven to be an effective and disruptive economic weapon. Given its importance, markets are likely pricing in a long-run oil risk premium rather than a more permanent supply disruption.
- Base Scenario: The timing is highly unpredictable, but a quick resolution appears unlikely without all sides in agreement. We instead see a rolling series of delays/ceasefires that drags on over a period of months until a final deal is reached to “end the war.”
- Under this scenario, the Strait of Hormuz can partially open, requiring a period of multi-country led ship escorts. WTI stays in $75-100 range through 2026 following bilateral deals partially opening the Strait, and the start of a Toll Booth (TB fee) concept where Iran collects crossing fees. Rates are expected to remain in higher range with market pricing for cuts getting pushed back.
Please see the PDF report link above for the full write-up with charts and forecasts…