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- This week marked the first round of major central bank meetings since the outbreak of the conflict in Iran, and unsurprisingly, with elevated risks around inflation, the language shifted more hawkish, with significant consequences for the benign path previously expected for interest rates in 2026. The US Federal Reserve (Fed) left rates unchanged at 3.5-3.75% and noted that developments in the Middle East had “uncertain implications” for the US economy. Fed Chair Jay Powell said that in the near term “higher energy prices will push up overall inflation, but it is too soon to know the scope and the duration of the potential effects on the economy”. An updated set of forecasts showed that Fed officials are expecting the PCE measure of inflation to end the year at 2.7%, up from the 2.4% predicted last December.
- The Bank of England (BoE) left rates unchanged at 3.75% in a unanimous vote and warned that a prolonged energy shock from the Gulf would drive up inflation and open the door to higher interest rates. Governor Andrew Bailey said the “appropriate thing” was to hold rates at this point but added that “I would caution against reaching any strong conclusions about us raising interest rates”. Bailey said that “the message had changed” as a result of the energy price shock and that cuts in rates were “not on the horizon” anymore. Previously, the BoE had expected UK CPI to ease to 2.1% in Q2 2026 but now expects CPI of 3%, climbing to 3.5% in Q3.
- The European Central Bank (ECB) kept rates unchanged at 2% with President Christine Lagarde commenting that the Bank is “well positioned and well equipped” to deal with “a major shock that is unfolding”. The ECB now expects inflation to climb to 2.6% this year, from a previous forecast of 1.9%. For the moment, inflation is projected to ease to 2% in 2027 and 2.1% in 2028. Lagarde said the war in the Middle East has made the outlook “significantly more uncertain creating upside risks for inflation and downside risks for growth”.
- The war in Iran continued to dominate headlines, with very limited shipping traffic continuing to navigate the Strait of Hormuz and rising risks of further escalation, following attacks from both sides on energy infrastructure, which up to this point had been relatively unscathed by the conflict. President Trump said he “knew nothing” in advance of Israeli attacks on Iran’s South Pars gas field, which is part of a larger field jointly owned by Iran and Qatar. In response, Iran attacked Ras Laffan, Qatar’s main energy hub and the world’s largest LNG facility with five ballistic missiles, four of which were intercepted. Trump did say that he would “massively blow up” South Pars if Iran struck Qatar again but said “no more attacks would be made by Israel” if Iran stopped its own strikes. QatarEnergy said Iran’s attack had caused “extensive damage”. Oil and gas traded higher yesterday on the escalation with equities and bonds selling off, with the mood not helped by the hawkish pivot from the central banks.
- The week began with President Trump claiming Iran was “ready to make a deal” to end the war but the US wants better terms and a “very solid” agreement that would include a commitment from Tehran to abandon nuclear weapons. Iran’s foreign minister Abbas Araghchi said Iran was open to “any regional initiative that leads to a fair end to the war” but ending the war is conditional on guarantees that it won’t be repeated and on the payment of compensation. Trump also called on other countries to send warships to open the Strait of Hormuz. This demand was rejected but the UK, France, Germany, Italy, the Netherlands and Japan have signed a statement expressing “willingness” to take part in efforts to ensure safe passage for ships through the Strait of Hormuz. UK officials say these are “very early days” and no such operation can take place until there is a major de-escalation of fighting in the region.
Market movers
Christine Lagarde, ECB President, has for many months been saying monetary policy is in “a good place”. The ECB was previously not expected to move rates at all this year; while for the Fed and the Bank of England, rate cuts were widely anticipated. But that “good place” is no more, after the energy price shock of the past month has completely shifted expectations of the path for inflation and interest rates. In the US, Fed Funds futures show that the next Fed rate cut is now not expected until July 2027, a significant shift from the pre-war outlook, when markets were pricing two rate cuts this year. Just a few weeks ago, a rate cut looked guaranteed from the BoE this week. Now, markets are pricing no further cuts at all, and indeed rate hikes look more likely. For the eurozone, two rate hikes are now expected over the course of this year. The backdrop is highly uncertain, as summed up by Jay Powell, who signalled not to read too much into current forecasts, adding “the thing I really want to emphasise is that nobody knows. The economic effects could be bigger, they could be smaller, they could be much smaller or much bigger. We just don’t know.” What we do know is central banks have recent memories of an energy shock in 2022, when already rising inflation was turbocharged by the shock resulting from Russia’s invasion of Ukraine, and central banks underestimated the size of the inflation wave, raising rates too late. If this is indeed a prolonged energy shock, then rates will likely rise sooner rather than later, followed by cuts as higher commodity prices slow economic growth. History shows the cure for high oil prices is demand destruction and economic slowdown. But for now, with inflation forecasts pushing higher, central banks will have few options other than to tighten policy, if it turns out this crisis proves to be longer lasting than hoped.
The investment lens
We are now at a crucial point in the Iran war where elevated energy prices continue to reflect huge levels of uncertainty. The potential for escalation, with both sides targeting energy infrastructure, poses further upside risks to both oil and gas prices. As the conflict is on the brink of a fourth week, there remain huge unknowns over the duration and scope of the conflict, and whether President Trump will seek an ‘off ramp’ sooner than later. Even if the US does seek to de-escalate military operations, both Israel and Iran may take a different view. Of course, the key question for financial markets and the global economy is the flow of commodities through the Strait of Hormuz. There is clearly no appetite from the international community to deploy military resources to the Gulf while the conflict is ongoing, and flows through the Strait are limited to a small number of vessels whose transit has been approved by Iran. Much like the central banks, we must remain in wait and see mode while these binary outcomes are resolved. Either we see a de-escalation on all sides, and the resumption of shipping navigation, potentially under a naval coalition to ensure safe passage, or we are moving into a more prolonged conflict, potentially escalating further if energy infrastructure is seen by both sides as a legitimate target.
We have moved from a benign backdrop at the end of last month into a period of extreme uncertainty. Bond markets are spooked by the prospects of higher rates and inflation; equities have sold off, but are showing some resilience, supported by unchanged (for now) expectations for earnings. However, the consensus view that this conflict would see some form of resolution in a matter of weeks and that positive views for 2026 can be maintained, albeit with rate cuts pushed further into the future, is coming under more scrutiny. Should this conflict continue to endure, with neither side in a mood for compromise, then the negative impact on the outlook for growth, inflation and rates will inevitably weigh more heavily on risk appetite.
