The desk is highlighting a challenging environment for central banks as geopolitical tensions, particularly the conflict in Iran, contribute to rising oil prices and a negative supply shock. This situation complicates the trade-off between growth and inflation, as discussed in the recent BofA Global Research podcast featuring Ralf Preusser and his colleagues. Per the full note source, the implications for monetary policy are significant, with central banks needing to navigate a delicate balance that varies across major markets. As traders assess these dynamics, positioning in rate markets is expected to shift, reflecting the evolving landscape of growth and inflation expectations.
What the desk is arguing
The conflict in Iran acts as a negative supply shock, pushing up oil prices and deteriorating the trade-off between growth and inflation for central banks. The podcast discusses how the repricing in rate markets varies across major markets, identifying value in curve positioning and attractive hedges.
Where it sits in our coverage
We do not have internal coverage data on the relevant currencies, so we cannot cite a consensus target or firm spread. The analysis is based on BofA's proprietary research.
How other firms see it
No other firms are cited in the provided commentary.
Key takeaways
01Iran conflict creates a negative supply shock via higher oil prices, worsening central banks' growth-inflation trade-off.
02Rate market repricing differs across major economies, offering value opportunities in curve positioning.
03Specific hedges are identified as attractive in the current environment.
Market implications
Higher oil prices due to the Iran conflict could lead to stagflationary pressures, with central banks facing a difficult choice between fighting inflation and supporting growth. Rate markets may see divergent repricing across countries, with potential for curve steepening in regions where inflation expectations rise more sharply.
Risks to this view
Further escalation of the Iran conflict could amplify supply disruptions, pushing oil prices significantly higher and worsening the stagflation scenario. Central banks may be forced to tighten policy aggressively, risking a recession. Conversely, a de-escalation could reverse oil price gains and ease policy constraints.
Hello and welcome to Global Research Unlocked, the interest rate and FX series. This podcast is based on our weekly client conference call where our strategists along with guests from other parts of BYA Global Research discuss the most topical and pressing questions faced by our market. I'm Ralf Preusser, head of Global G10 rates and FX strategy.
Today is Friday, 13th of March. I'm joined today by Bruna Brasinha from the U.S. rate strategy team, Mark Cabana, head of U.S. rate strategy, and Sphia Salim, head of European rate strategy. Thank you all for joining me.
Sphia, let's start with you. We've seen a major repricing of the front end of both the euro and the sterling curves. Talk us through what happened.
Yes, indeed. It's quite a dramatic repricing. So in the euro area, one year, one year surged by 50 basis points since February 27.
We moved from pricing 10 basis points of cuts this year to pricing in 40 basis points of hikes. So the market is even implying a 30% probability that the first hike will be delivered by the April meeting with a full 25 basis point hike priced in for the July meeting. In the U.K., the moves were even larger.
One year, one year surged by over 70 basis points. The market is now pricing in 15 basis points of hikes for this year, when before the strikes on Iran, we were actually pricing in 50 basis points of cuts, 20 basis points of which were priced for the meeting next week. How do you explain the extent of the sell-off?
How much of that is just positioning on wines? I think initially, probably a lot of it was positioning because we had very consensus received positions, in particular, in one year, one year, two year, one year. That was the case because those received positions were actually providing a very good role.
And that was also the case both in euro and sterling. On top of that, I think that in the U.K., we had seen the BOE move a bit more on the dovish side. So there was a very large consensus, long positioning in the very front end as well.
Surely, some of it also has to be fundamental. You're not just going to price in hikes because of positions being unwound. No, for sure.
Yes, I think that positioning just exacerbated the move initially. But I think there is certainly, yes, a fundamental aspect to it. And for the euro area, that's the case in particular for fixed pricing.
Our economists already acknowledge the possibility of hikes being delivered this year. Specifically, they believe that if there is no clarity by the June meeting on when the oil shock might fade, then it is likely the ECB would hike rates then or shortly thereafter. And if you think about that scenario, the ECB would not stop with one hike.
It's likely they will consider a small series. And our economists would expect in that scenario 50 to 75 basis point of hikes probably by the September meeting already, which if you think further out, would then be followed by cuts and deeper cuts in 2027. But certainly, this is fundamentally a reason to be pricing in some hikes in 2026.
In fact, if you look at the current pricing, you can say that it's consistent with this view and the idea that maybe according to PolyMarkit, there could be a 55 percent chance of a U.S.-Iran ceasefire by the end of May. If you take the 50 percent probability that this doesn't happen and oil prices remain elevated, then I think pricing of 35 basis point of hike by September is really consistent with that mini cycle. For the BOE, yes, our economists also changed their call for the March meeting from a cut to on hold.
So they are taking on board indeed the energy shock impact, but their baseline remains one of two cuts this year, just delayed to June and September, really because policy is still very restrictive in the UK. We have wage growth even in the labor market considerably weaker than in 2022, the last energy shock. So to us, if the move is only temporary, it only delays the disinflation trend and therefore just delays the easing cycle.
Really to be considering hikes in the UK, I think you need a much more prolonged shock than in your area. We'll need to see inflation remained in the three to four percent range throughout the second half of this year at least, we think. Great.
And what exactly are you looking for from the ECB and Bank of England next week? You already mentioned that we no longer expect the Bank of England to cut, but what should we look out for in the communication in particular? Yes, so for the Bank of England, we think there will be a seven to two vote with Taylor and Dhingra likely still favoring a cut.
The communication will be interesting and our economists expect the easing bias to be kept in the minute, but made conditional. Conditional on a relatively quick reversal of energy prices. And I think that comments also on potential hikes will clearly be monitored by the market.
We expect the BOE to emphasize that the bar for hikes is high and would need sustained high inflation and a de-anchoring of inflation expectations for that to be considered. Now for the ECB, we're expecting them to stay on hold. That's really consistent with market pricing, but two things will be monitored.
Of course, the language first, but also the forecast update on the language. The ECB is likely to emphasize those upside risk, new upside risks to inflation. Also likely to tell us that they need to understand the persistence of the shock before taking any decisions.
Now I'd say that whether or not they keep the reference to being in a good place will be very important for the market here in terms of the signal forward. On the economic projections, what's challenging is that the usual cutoff date that they use for their assumptions is just before the outbreak of the Iran event. So the ECB might give us maybe some alternative scenarios, in which case our economists estimate that if those alternative scenarios use the technical or the prices just this week and the futures this week, then the ECB may show headline inflation just above 2.5% this year and 1.7% to 1.8% in 2027.
Then it will be a matter of figuring out whether the ECB emphasizes these upsides to near-term inflation projections or if they look through them and discuss more those lower inflation prints ahead. Thank you. What does that mean for the curve in Europe in particular?
The curve has clearly been dominated by their flattening moves. That's very much consistent with the large front-end repricing. So we've seen the beta, for example, of 10-year boons versus the front-end at around 0.7.
We think that can persist if energy prices remain elevated in coming weeks. I would even say that for Tuscany, the flattening has been a bit less pronounced than what we could have expected based on global dynamics. Tuscany's curve is actually flattened by 10 basis points more, given the flattening seen elsewhere.
So we think that if the energy prices remain elevated by June and we have to really consider the scenario from our economist of a proper hiking cycle from the ECB, we could end up with an inverted 2's-10's curve. In the long end, there were lots of stopouts on steepeners that exacerbated the move initially in 10's-30's. But there again, the flattening has not been as large as what you could have anticipated given the relationship 10's-30's versus 2's-10's involved.
We do see scope for the 10's-30's curve to invert as well in coming weeks if energy prices again remain elevated. Thank you. And then last for this section, how about the break-even real yield dynamic in Europe?
Does it make sense to you what we're seeing? It depends what period you consider. The initial move in the real rate curve was one of their flattening.
So when the market implied a significant policy tightening from the ECB that even dominated over break-even moves, and we had even higher real rates in medium term, which just didn't make sense. We do need to be a bit cautious when interpreting all the moves, break-evens versus real in volatile markets. It could be dislocation, but it is worth noting that this dynamic changed from this week.
The real rate curve booms deep, and while the break-even curve there flattened. Mark Capelton analyzed that in the weekly today, and his interpretation is really that the market may have initially seen the ECB as willing to impose a certain amount of pro-cyclical pain, so delivering these higher policy real rates to contain inflation. However, maybe this week we've reached the point where the market has started to focus on the growth risk, and the point beyond which the ECB's expected reaction function becomes one that is more focused on stagflation risks, where maybe the cost benefit of further tightening policy rates are too negative.
And we think this new dynamic might be the one that persists a bit longer when it comes to real versus break-evens daily rates. Thank you. Bruno, let's come to the vol market.
We've seen quite a strong reaction, of course, but not all vol markets have reacted the same. Where has the reaction been the most significant? The euro vol market had a really remarkable reaction, not only in terms of the magnitude of the moves, call it the first principal component move, but also in terms of the three rotations of the vol grid.
So the first one of those would be the term structure volatility. You saw an inversion of the term structure volatility of roughly 10 normal in the euro grid compared to roughly flax term structure for US marginally inverted there. And then the second rotation would be the performance of the left side versus right side.
You saw moves in vol on the euro grid on the left side of the grid of roughly 80 normals, 75 normals. You only see those moves when you see a material shift in policy expectations. So that implied roughly 25 normals flattening of 1-year, 1-year versus 1-year, 10-year in euro grid versus 10 to 15 normals in US and, compared to Japan, a steeper grid in Japan because, paradoxically, the Japan curve bears steepen in this move.
And the right side vol got beat versus left side vol. And then, obviously, the third dimension being the skew. We saw a massive reversion of the skew dynamic with players getting beat versus receivers versus, obviously, the opposite dynamic early in the year.
So very significant sharp moves in euro grid in absolute terms, but also relative to what we saw in US grid, Aussie vol grid, Japan grid, and so on. Why do you think that is? You mentioned the pricing and changes of policy expectations.
But to what extent do you think carry trades in vol played a role in Europe too? Yeah. So I think those are the two key elements that drove this repricing.
The carry obviously played a significant role. The market had built a very heavy, long carry, short vol bias in positions. And this is a weird state of complacency because, in conversation with clients, a key theme that kept coming up in meetings was a source of potential shocks.
And geopolitical risks, and Iran in particular, was one of the key known unknowns that was often mentioned in these meetings. But still, the market stayed very long carry with some sense of inevitability in this bias. And obviously, this shock forced a material reversal of these trends, an unwind of the short vol bias, and explains some of the euro vol outperformance, because euro vol was the focus of a lot of that short vol bias.
But obviously, the repricing of expectations around the central bank trajectory was another material driver for this. And obviously, the bear flattening that we saw, the magnitude of the bear flattening we saw on the curve is reflected in the magnitude of that outperformance of the left side versus right side. When the central bank moves from cuts to hikes, it's much more significant than when you move from two cuts to one cut, which is what we saw in the US.
Or when policy expectations virtually see no change, as we saw in Japan. So both of these drivers, the unwind of the carry trade, but also the pricing of central bank expectations, were the key drivers for the outperformance of euro vol. When you look at what the vol market is pricing now, in both dollars and euros, do you think that's broadly fair?
Okay, so fair is a concept that does not apply easily in acute phases of crisis, right? But when I look at the magnitude of the moves in the curve, the bear flattening we've seen, when I look at the policy repricing, the current vol levels and the vol differentials across markets are in the context of the upper range of what I would expect to see in an acute phase of the repricing of a shock of this magnitude. There is scope for vol to fade.
And in fact, we saw a little bit of a tentative fade early in this week, as the conflict seemed to be moving away from the acute phase to sort of a chronic phase. But obviously, as tensions increased, and straight up almost volatility picked up again. For now, our biases continue to be in a long vol bias, short duration bias, continue to express those near term in positioning.
Eventually, there's scope for volatility to fade, but the timing is uncertain. So I would not make that call right now. Thank you.
Mark, let's come to the US, third central bank meeting to discuss on this call out of eight, and not that we're discussing the remaining five, but I don't think I've ever seen eight central bank meetings in my space in one week before. What do you expect from the Fed next week? Not much.
The Fed will release their summary of economic projections. Our economists anticipate that they will move up their readings on growth a smidge in 2026 by a tenth, and also move up their estimate for core PCE inflation at the end of this year by two tenths, from 2.5 to 2.7%. But even with the slightly better growth and slightly higher inflation, they anticipate that the Fed will keep the median unchanged at 3.375%.
And there's a relatively high bar for that to move up because according to the dot plot, the last time it would take three individuals to move seems unlikely to us. The readings in the FTP from 27 and 28 will also be unchanged. The longer run dot may very well tick up at the median by one eighth from 3 to 3.125.
But we don't think the market's going to read all that much into such a move, and it would only take one individual to affect that upward drift in the longer run dot. There will be some changes to the FTP, but we don't think that those are going to weigh heavily on how the policy outlook is described. It goes without saying that the Fed will leave rates on hold, but what the big focus in the market will be is how does Powell discuss the risks of the big oil price increase.
And there, we assume that they will build off of something from the March 22 statement. Remember, that was the first meeting after Russia invaded Ukraine. And it'll probably read like implications for the economy are highly uncertain, but in the near term, the conflict does create additional upward pressure on inflation and the potential to weigh on economic activity.
Powell will likely highlight stagflationary changes. He will likely be relatively noncommittal about what that means for near-term policy, and we anticipate that he will reflect a wait-and-see approach. If we get all these things, what does it mean for rates?
Likely very little, simply because there will be minimal forward guidance that is provided, and the market will continue to focus more on how the recent jump in oil impacts the overall outlook for inflation and growth. So on that, it's an important meeting, but it's unlikely to result in much sustained price action. Thank you, Mark.
Similar to the question for Sia, obviously, this is a stagflationary shock for the U.S. economy, too. You already talked about the fact that the Fed will acknowledge upside risks to inflation and downside risks to growth. But what risk do you think the U.S. rates market today is actually mispricing?
Is it mispricing inflation? Is it mispricing growth? Is it mispricing both?
We think it's mispricing growth more than inflation. We have certainly seen that shorter-dated measures of inflation compensation have moved up. That's very consistent with oil, very consistent with how rates typically respond to geopolitical shocks.
It mostly initially reacts to upside inflation risks. And we think that's reasonably well-priced. Consistent with that, we did remove our recommendation to be long 10-year break evens.
But what we think the market is still missing is the downside risks to growth. And as a result of that, we just think that real interest rates still look a little too high. And we think that the market is inadequately pricing the backside of the inflation jump and the commodity price jump.
We think that central bank reaction functions, especially the Fed's reaction function, is very asymmetric when facing higher oil prices. One very simple summary statistic that I think very clearly reflects this is that if you look at how the Fed funds rate has moved on average in the face of upside and downside oil shocks over the last almost 30 years, what you see is that it's not a symmetric response. For example, if oil goes up 25 basis points in six months, on average, you typically only see the federal funds rate move higher by five basis points.
However, if oil goes down 25% in six months, you typically see Fed funds drop 50 basis points. And the magnitudes become even more stark if you look at a 50% move in oil. To the upside, Fed funds only moves 25 or so basis points.
And if oil drops 50%, you typically see the funds rate go down 150 basis points. So to us, what we worry about now is that the market is only focused on the upside oil price shock. And let me be clear, we don't know how big this move will be and we don't know how persistent it will be.
But the market, we think, is only focused on the upside move and it's not focused on the likely future reduction in oil prices whenever tensions cool. And when that happens, we expect that we will see further signs of growth concern. And we think that the disinflation that goes along with oil eventually normalizing, wherever that may be, probably not $65 a barrel, but $75, $85, something like that.
When that happens, that has typically corresponded with pretty large central bank cuts. So we think the market is not adequately focused on the growth risks, nor is it adequately focused on the likely eventual stabilization, if not decline, in oil prices. Great.
Thank you. Thank you, Svea. Thank you, Bruno.
Thank you, Mark. Thanks for joining us today. We hope you found this useful and that you'll tune in next week.
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