A week packed with war headlines and central bank decisions comes to an end with one clear conclusion: the Middle East conflict is intensifying, and no one knows what the right monetary policy response should be.
What everyone agrees on is that rising oil and energy prices will push inflation higher in the short to medium term—depending on the duration of the conflict—while weighing on growth. This is a message echoed by the major central banks around the world.
The Reserve Bank of Australia (RBA) raised rates for a second consecutive meeting earlier this week. The Federal Reserve (Fed) chose to remain cautious, with the dot plot still pointing to a rate cut this year if inflation trends toward the 2% target—which, frankly, is a wishful thinking. The Swiss National Bank (SNB) has more room to breathe, with inflation in Switzerland nearing 0%. Meanwhile, the European Central Bank (ECB) and the Bank of England (BoE) sounded more concerned than their American counterpart about inflation—unsurprisingly, as Europe is a net energy importer and the euro and pound have weakened against the US dollar since the start of the conflict, meaning inflation could hit Europe harder.
How hard? In a severe scenario presented by the ECB, inflation could peak at 6.3% in Q1 next year. Let’s hope it doesn’t.
Encouragingly, the ECB’s baseline forecasts are less extreme, although yesterday’s update pointed to higher inflation and slower growth over the next three years. If it offers any reassurance, Christine Lagarde noted that since the Ukraine war, “we have learned, improved our models, changed our strategy and are now more attentive to risks around the outlook.”
That said, the reality remains challenging: the ECB is facing another energy shock, and there is essentially one conventional tool to respond to the resulting inflation—raising rates. Markets now fully price in two 25bp hikes this year, with around a 50% probability of a third. That’s the takeaway from the meeting.
The rise in German and French yields reflects these inflation expectations and rate hike bets—both have climbed to their highest levels since 2011. The STOXX Europe 600 is feeling the pressure: the index lost around 2.4% yesterday. The trigger, however, was not the ECB decision but the spike in energy prices, with Brent Crude briefly approaching $120 per barrel as the conflict between Iran and Israel continued to damage energy infrastructure in the region.
Oil prices are calmer this morning after US calls to avoid targeting energy infrastructure—reportedly met with a more constructive tone from Israel—and on news that Washington is considering easing sanctions on Iranian oil. Unbelievable!
Meanwhile, France, Germany, Italy and the UK said in a joint statement that they would support efforts to keep the Strait of Hormuz open. But to be willing to help is one thing, being able to help is another. So despite a relatively calmer morning session, the uncertainty and the volatility will remain on the menu.
This same backdrop also led the BoE to keep rates unchanged yesterday. The Monetary Policy Committee voted unanimously to hold—contrary to earlier expectations for a rate cut prior to the escalation in tensions. And the MPC is rarely unanimous! More worryingly – but as widely expected and priced in, the BoE opened the door for rate hikes down the road to ‘respond to the risk of a more persistent effect on UK inflation’. Bailey still said he cautions ‘against reaching any strong conclusions about raisin rates’, but in fine, we all know that if oil prices remain high at the pump, rates will have to rise.
The challenge is that raising rates in response to an external supply shock is only partially effective. Higher rates won’t end the war, repair damaged infrastructure, or directly lower energy prices. What they can do is slow growth and dampen demand, helping to contain—though not necessarily reverse—inflationary pressures.
Against this backdrop, rate expectations are not particularly supportive for European currencies. Both the EURUSD and the GBPUSD rebounded yesterday, likely on a softer US dollar amid tentative geopolitical de-escalation signals. But both pairs are back under pressure this morning.
So what’s next? No one knows. Meanwhile, US authorities are reportedly considering proposals to ease bank regulations, including lower capital requirements. This could help banks navigate rising private credit stress more smoothly, but it would also leave them more exposed to future shocks.
We are heading into what will likely be another eventful weekend in the Middle East. Investors are unlikely to add significant risk ahead of that, so the week may end on a cautious note, with only a slim hope that coordinated efforts could ease tensions around the Strait of Hormuz.
More realistically, oil and gas prices are likely to remain biased to the upside, with high volatility leading to sharp swings in both directions. Uncertainty will keep market participants on edge.
Some point to China as being relatively insulated from the Middle East conflict, given its energy reserves and investments in alternative energy—and, in a worst-case scenario, its ability to fall back on coal. But China faces its own challenges: an ageing population and a deep property crisis.
While AI and tech have recently supported sentiment, Alibaba Group disappointed investors with a 67% drop in quarterly profits and modest revenue growth, sending its shares 7% lower in New York. The company is aiming to offset slowing e-commerce growth with AI-driven revenues, but investor patience appears to be wearing thin.
