Another week with volatility induced by the Iran war seems to be ending with oil prices lower, equity prices higher and reduced expectations of interest rate hikes. Reports of progress towards a degree of peace and a potential reopening for traffic through the Strait of Hormuz is largely behind the relative optimism. A key step was the 10-day ceasefire agreed on Thursday between Israel and Lebanon, as an end to the fight there is a key Iranian demand. However, all agreements so far are temporary and appear fragile. For example, Iran and the US seem to have very different views on what will happen with Iranian nuclear resources and with shipping conditions through the Strait of Hormuz, and Hezbollah does not seem convinced about the ceasefire in Lebanon. Hence, there is a clear risk that sentiment could worsen significantly again in coming weeks.
As oil prices have declined, so have expectations of higher inflation and interest rates. We have tweaked our expectation for the ECB, so we now expect a 25bp rate cut in June and another one in July, rather than in April and June. This is based both on the decline in the oil price and on what we see as a slight shift in the signals from the ECB governing board members. In particular, news reports this week said that the board has more or less ruled out an April rate hike.
The short-term interest rate outlook is very dependent on the preferences and analysis of the policy decision makers, as the decision on whether to respond to the oil supply shock is not a clear-cut one. We expect that there will be a response because of the fear that inflation expectations will become engrained, with the 2022 inflation still very much being top of mind. However, there is also a good case to be made that the central bank should not move, as higher energy prices will dampen the economy and that higher interest rates will make that problem worse. That is also why we expect that if rates are hiked, they will be cut again during 2027.
March data has in general shown no or only a modest response to the Iran war in economic activity and non-energy prices. This week we got data for China, where Q1 GDP growth surprised to the upside at 5.0% y/y and house prices declined at a slower rate than previously. However, retail sales are growing at only 1.7% y/y, so the weakness in domestic demand remains.
Next week, we will start to get data for April, most importantly the flash PMIs for most major economies on Thursday. Especially in Europe, we expect to see a sharp decline in manufacturing due to higher energy prices, and the price components could give some important clues about whether energy costs are filtering through to other prices. Note that PMIs can be more difficult to interpret in times of high volatility though. For example, longer delivery times increase the headline index, so also keep an eye on the output subcomponent.
In general, even if energy prices continue to decline over the coming months, we still expect to see a negative effect on economic growth for 2026 in most major economies.
