Top of the Morning: CIO Strategy Snapshot - Shocked but not awed
Per the full note UBS-on-Air, the CIO office sees the Fed holding steady amid sticky inflation and a resilient economy, with the median dot still pointing to one cut in 2027. The Iran conflict risk premium is fading, but the selloff in risk assets has been contained so far. The desk argues that the next central bank move could be a hike rather than a cut, challenging consensus dovish expectations. With no high-impact calendar events in the near term, the focus is on whether oil prices derail the disinflation narrative.
What the desk is arguing
The desk frames this as a market that has been shocked but not awed, with the U.S.-Iran war entering its fourth week without a major escalation. Risk assets have been relatively resilient despite the geopolitical uncertainty and the possibility that central banks may next hike rather than cut. The FOMC left rates unchanged and the median dot still implies one rate cut this year and one in 2027, but growth forecasts were revised higher alongside inflation expectations, suggesting a higher-for-longer regime.
The supporting evidence leans on the Fed's upward revision to 2025 GDP growth despite higher oil prices — a combination that historically has led to rate hikes, not cuts. The desk implicitly rejects the alternative read that the economy is softening enough to warrant easing, instead seeing the resilience as a reason for the Fed to stay on hold or even tighten.
Where it sits in our coverage
No internal coverage data is available for this commentary, as no tracked currency pair was identified. Therefore, this section is omitted.
How other firms see it
No per-firm forecasts are available in the internal coverage block, so this section is omitted.
What the calendar says
No high-impact events are scheduled in the next 30 days for this jurisdiction, so this section is omitted.
Key takeaways
01The Fed's revised higher growth and inflation forecasts support a higher-for-longer stance, with rate cuts delayed.
02Geopolitical risk from the Iran conflict has not escalated, but oil prices remain a key variable.
03Risk assets have shown resilience, but the possibility of a rate hike is becoming a real tail risk.
04The desk expects the next major move in rates to be up, not down, challenging consensus dovish positioning.
Market implications
Watch for a further steepening of the U.S. yield curve if the Fed's hawkish tilt is confirmed. A break above 4.6% on the 10-year UST yield would confirm the higher-for-longer narrative. The upcoming oil price reaction to any new Iran supply disruption is the near-term catalyst.
Risks to this view
The call is invalidated if a sharp economic slowdown forces the Fed to cut despite sticky inflation. A major escalation in the Iran conflict that disrupts oil supplies could create a stagflationary shock that overwhelms the Fed's rate hike bias.
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Hi everyone, Dan Cassidy here. Welcome back to Top of the Morning on the UBS Market Moves podcast channel. The war with Iran has entered its fourth week and the risk of escalation appears, at least for the moment, not to be happening.
In addition to trying to forecast how the conflict will evolve, investors are now also dealing with the possibility that the next move for central banks may be to hike rates rather than to cut them. Risk assets have been selling off but have been relatively resilient in the face of all these shocks. So joining us on this Monday morning to discuss this all, I'm glad to once again welcome back Jason Draho, Head of Asset Allocation for the Americas from the UBS Chief Investment Office.
Jason, welcome back. Thank you for joining our listeners, our clients, to kick off another trading week. Thank you, Dan.
Good to be here. Well, I guess the start of spring, so hope spring's eternal, so maybe better times ahead. Exactly.
Hopefully turning the corner. So a lot to catch up on, Jason, since you and I last spoke a week ago from today. Let's perhaps begin with the outcome of the Fed meeting last week, which we did preview, as well as some of those other major central banks.
What are some of the takeaways from what we heard and what's your outlook from here? Well, the outcome from the Fed meeting in some ways was sort of consistent with what we'd expected. The Fed did not hike rates, or sorry, cut rates, which was widely presumed.
There was not a change in the DOT plot, so the median DOT is still calling for one rate cut this year, one rate cut in 2027. What did change a little bit was the expectations for growth for this year. They actually revised higher their growth expectations this year.
They did take up their inflation expectations as well, but the increase in growth was a little bit surprising in light of what's going on with higher oil prices. I guess what was perhaps a little bit surprising from the overall takeaway from the FOMC is that Fed Chair Jay Powell came across a little bit hawkish during his press conference. I think at least relative to expectations that we had kind of going into it, the challenges that Fed faces was already a persistence of inflation above the 2% target.
Now you add on top of that the oil prices going higher because of the conflict in Iran that's going to lead to higher headline inflation for March and kind of going forward. The question is how much would the Fed be willing to look through this or not? Would it focus on just purely inflation risks, or would they also then care about the downside risks to growth that higher oil prices, higher gas prices could entail?
The emphasis seemed to be a little bit more on the inflation risks and not necessarily emphasizing that the risks are both two-sided. There's risks now, so increasing risk to the labor market. So as a result, the market price for cuts this year declined a little bit from pre to post-Fed meeting, but the real change in the market narrative regarding central bank rate cuts happened not on Wednesday after the FOMC, but on Thursday after the Bank of England and the ECB had meetings where they basically both kind of came out and were relatively hawkish.
And as a result, market pricing really shifted pretty dramatically after that. It was compounded by the fact that it looked like the conflict was escalating, that energy prices could be further disrupted, that inflation would linger longer, and that central banks would have to deal with this kind of inflation shock. But just for context, three weeks ago, right before the conflict began, so as of February 27th, the market was expecting 2.4 Fed rate cuts this year.
Now it's pricing, at least as of Friday's close, nearly a 40% chance of a hike this year. The repricing expectations are even greater for the ECB and the Bank of England, where the markets are now pricing in three rate hikes for the ECB and two rate hikes by the Bank of England before the end of 2027. So a pretty dramatic shift towards easing towards kind of hiking rates.
For those other central banks in Europe, they only have an inflation mandate, whereas the Fed has a dual mandate of price stability and full employment, so that's why the market would be a little more cautious on the Fed. But when we look at this, this seems extreme kind of in terms of how much the market has shifted in a very short order. It seems very unlikely that the Fed would actually look to hike rates at all this year, especially if Kevin Walsh is confirmed as the next Fed chair, who's been sort of dovish leading up to his nomination.
It's likely the Fed will maybe wait to do anything, they just need more clarity on how this will all play out. I think the bar is very high for any sort of hikes, and it's gone up a little bit perhaps for cuts, but ultimately we still think the Fed's going to cut this year. We're still looking at two cuts, I think, but now the timing is more in doubt, and given this inflation, near-term inflation shock, it may not happen until the second half of this year.
But definitely we're of the view that the next move is a cut, not a hike, as the market is currently pricing. Now, Jason, something interesting to note, the word stagflation is being floated once again, and Fed Chair Jay Powell even addressed it during his press conference last week. What do you think?
Is stagflation a real risk here? Well, let's just define what stagflation actually entails. You know, there's a term that began in the 1970s when you had both high inflation, but also low growth and high unemployment.
So in the 1970s at some point, inflation was 10%, but the unemployment rate was also close to 10% after some recessions. And so we're not even close to that, and that's what, you know, Powell mentioned in his press conference, that this is not the 1970s, it's not necessarily a fair comparison. There are multiple policy areas at that point in time.
Inflation was much worse, unemployment was higher. Combined, you know, the unemployment rate, the inflation rate was around 20. That's kind of the, you know, the misery index is sort of the sum of those two.
If you add up inflation right now, at sort of 3% inflation and about 4, 4.5% unemployment, we're looking at a misery index of about 7.5. So less than half of what it was back then. We're also dealing with a situation where, yes, this is an oil price shock that would push inflation higher, it can be a drag on growth.
But going into this conflict, you know, growth data was okay. The labor market data that we have in real time is still holding up, but layoffs remain very low. Global PMI, I think it's manufacturing index, were actually improving going into March.
So the economic momentum looked like it was accelerating going into this. This is also a very specific price shock, it's to do with oil. There is some comparisons more not in the 1970s, but from 2022, when inflation went higher, the Fed had to hike rates as well as other central banks.
But at that point in time, inflation was much more broad based, it was coming as a pandemic, there was supply issues all over the board that was causing inflation to go higher. The inflation rate in the US, the CPI, was over 8%. Now it's hovering around or even below 3%, it's likely to get up to over 3% in the next couple of months.
The economy was stronger, job growth was stronger, fiscal policy was more supportive. So even in the comparison to 2022, it feels like the conditions are very different today. So bottom line out of all this is that people will use the word stagnation, but in terms of the actual economic data, it does not look like stagflation at all.
It looks like, you know, ultimately growth won't be quite as strong as perhaps we anticipated. Inflation will be a little bit higher, but still a relatively, you know, constructive economic environment overall for 2026, assuming again, the situation with Iran starts to de-escalate, you know, in the not too distant future. So just to touch on the market environment as of late, Jason, and to tie in your recent blog, the title is Shocked but Not Odd.
Financial markets are down, however, you do state in your blog that this appears to be due to an inflation and rate shock, not growth fears. Why do you think that's the case? Well, let's just look at the market performance since February 27th, that's the Friday before the conflict began on that weekend.
Since that time, and this is the data on all sites through Friday's close, not as of early Monday morning, the S&P 500 was down a total of 5.4%, you know, over that time period of three weeks. The MSCI All-Country World Index was down just over 7%. In terms of sector performance, you know, defensive sectors are not clearly outperformed cyclicals.
I mean, utilities have done okay, but staples, healthcare, you know, they haven't, whereas energy industrials have actually done okay. If we look in corporate credit and corporate bond spreads, whether it's investment grade or high yield, they're out, you know, five to 20 basis points wider, respectively. You know, that understates how much they've moved because earlier in February, they were already starting to widen because of these growing risks in private credit and sort of these systemic concerns.
But by and large, they're still relatively contained. And you consider these moves to risk assets in light of the move higher in treasury yields across the entire curve. Over that time period of 52 basis points higher in the two-year, 44 basis points higher in the 10-year, like all SQL higher yields should lead to lower equity valuations.
So to get your equity only down that much, given those, you know, the moves and rates, you know, ultimately kind of suggests, you know, a fair amount of sort of resiliency and not necessarily growth concerns. And the yield curve, the treasury yield curve, bear flattened, meaning the front-end yields went higher than the back-end. And when that happens, that's usually not indicative of growth in the way that if the curve was bull flattening because the 10-year yields were falling instead of, you know, resiliency pricing and future rate cuts, that would be a real signal of growth concerns.
So we're not seeing across the glasses real evidence of growth concerns. The question is why is that? I'd say perhaps most important is that as investors, you know, have been sort of banking on the Trump administration, ultimately trying to stick to a four to five-week kind of duration for military strikes, you know, followed by an attempt to deescalate by early April, that would allow a gradual increase in the amount of oil passing through the Strait of Hormuz.
And then that would allow oil prices to kind of gradually decline. And we're not going to get the spike to like $125 a barrel. So the idea that you get this pivot in policy was I think a key thing that investors were looking at.
They've also, I think if you look at past geopolitical events, you know, what you see typically is that the S&P will be down, you know, between say five and 10% in the first few weeks. And then ultimately six months after the, you know, the event began, the S&P is higher. And so I think, you know, history tells us to kind of look through these geopolitical events.
And I think investors have been sort of willing to try and look through this to some extent. And then just to reiterate a point I made a minute ago regarding, you know, growth, it was a point to accelerate going into the conflict. So it provided some cushion against the shock.
So all told, it does seem like it looks like more like an inflation shock. You've seen that our rates moved dramatically higher in response to that, but the markets and investors haven't really been too concerned about kind of growth really deaccelerating. My confidence won't last if oil prices do rise above $125 a barrel for any sort of extended period of time.
And just late last week, we saw some signs of kind of these growth concerns creeping in because copper fell 8% last week, it tends to be a leading indicator. We're still seeing signs of oil prices and treasury yields going higher, but last Thursday you actually saw, you know, the 10-year go a little bit lower, even as oil prices went higher. If that correlation turns negative, that's a sign that the market is really worried more about the growth impact from higher oil, not the inflation impact.
So we're not there yet, and obviously given that the situation, even as the Monday morning is moving, you know, it kind of reinforces the view that I think investors still openly believe this will be a temporary inflation shock, leads to a little bit higher rates, but it's not necessarily going to be a growth shock. In terms of how to position, Jason, in this environment, let's end today with asset allocation. The question being, is what should investors do in light of all these shocks and the cross currents of escalation and de-escalation scenarios?
This all remains quite fluid. It is, well, as you say, very fluid because as of kind of late on Friday, the concern was that the situation could escalate because, you know, President Trump had put a 48-hour deadline on, you know, the straight opening up. Otherwise, we will launch military strikes against, you know, energy production and power production in Iran.
Iran then threatened to, of course, respond in kind. As of then, Monday morning, we've seen, you know, these tweets, but other comments from President Trump, you know, talking to various media outlets, you know, suggesting there's been negotiations, you know, between the two conversations that he's imposed a five-day pause on any sort of strikes on these power facilities, and also that there is, you know, they're looking towards, you know, working towards making a deal. So we went from one extreme of escalation to now it appears to be de-escalation, but obviously things could reverse, you know, fairly quickly because, you know, responses from various Iranian media outlets would suggest that there has been no negotiations, so it's a little bit of, he said, she said, it's still unclear exactly what is the reality.
But it does look like this escalation risk has been taken down at least a little bit as of Monday morning. All this means that for investors, obviously, it's a difficult situation to navigate, and we did put out some CIO note on Sunday night titled Managing Escalating Risks, and the key points are, you know, to stay invested, you know, position for upside, you know, because you're trading these geopolitical events is really a running strategy, and we can see Monday morning whether it's happened, and investors are kind of forward-looking for any, you know, there'll be any sort of a quick market rebound is likely to have any signs of an end to the conflict, and again, that's kind of what we're seeing Monday, but this could change within the next, you know, 24 hours. I think what investors can do is, you know, in the meantime, if they're overly aggressive at risk, you know, maybe to kind of progressively, you know, reduce portfolio risks, you know, the longer this crisis lasts, make sure you're diversified globally to perhaps reduce some cyclical exposure because, you know, there's still, even if the conflict de-escalates, still concerns about the potential for cyclical acceleration globally.
Things that we like, you know, especially given the big movement rates in the last week as the front end of the curve, so like, you know, the two years moved a lot of, you know, quite aggressively to price in those potential Fed rate hikes. We think that's overdone, so that becomes kind of more attractive as the front end of the curve. Gold has sold off dramatically, especially later last week, you know, 8% just in a couple days on Thursday and Friday.
Some of that is due to these higher rates of expectations that could send for banks hiking. We think, again, that's overdone. There's probably also some de-risking of portfolios and investors selling their winners, you know, to raise cash, and gold has done very, very well over the past year, but ultimately, you know, these geopolitical questions, the reasons to diversify, you know, from the dollar, those still persist, so we still see upside in gold, and of course, oil is, you know, probably the purest hedge to, if the situation does actually ultimately kind of escalate again.
So, bottom line is, you know, to stay invested, you know, to not necessarily take any kind of big swings, and there's certainly movements in the market just in the past few days that suggest opportunities, whether it's the front end, you know, short kind of maturities or gold, that we think that, you know, become more attractive because they overshot, you know, our views of where things will actually play out. Jason, very helpful guidance and update today in consideration of how many fluid factors out there are influencing markets, so thank you for joining us, Jason, to kick off another trading week, and do look forward to picking back up with our conversation next Monday. You're welcome.
Have a great week. You as well. Thank you, Jason.
And again today, we have been joined by Jason Draho, Head of Asset Allocation for the Americas from the UBS Chief Investment Office, and I once again want to highlight Jason's latest blog. That title is Shocked But Not Odd, is available for you now up on UBS.com slash CIO, though for clients of UBS, simply reach out to your UBS financial advisor if you would like to receive a copy of Jason's blog directly. From UBS Studios, I'm Dan Cassidy.
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