Investors are wrong to bet the European Central Bank will raise interest rates this year while the Federal Reserve cuts, Citadel Securities said, arguing that the oil-price surge makes such policy divergence unlikely.
With the conflict in the Middle East lifting crude oil prices above $100 a barrel on Monday, interest-rate swaps show traders have fully priced in at least one quarter-point hike by the ECB by December, and are leaning toward a second one. Meanwhile, they expect the Fed to lower borrowing costs by a similar amount in that period.
Those expectations are misplaced because the oil shock will likely weigh on economic growth in Europe and the UK — both net energy importers — more severely than in the US, a net oil exporter, Nohshad Shah, head of EMEA fixed-income sales at Citadel Securities, wrote in a client note.
“The growth drag in the US” from the oil shock is “modest relative to Europe and the UK,” Shah wrote. “If the ECB is hiking, I struggle to see the Fed cutting. And vice versa.”
Citing a Bloomberg Economics model, Shah estimated that a $20 oil price increase would likely reduce US gross domestic product growth by 0.05%, compared with a decline of 0.19% in Europe and 0.16% in the UK.
At the start of the week, worries around the risk of a tandem threat from hotter inflation and softer growth roiled markets. Traders have consistently been pricing in Fed easing this year, in part amid signs of a cooling labor market. Surprisingly weak US employment data last week underscored the Fed’s dilemma as it contends with safeguarding the labor market while containing inflation amid the oil shock.
West Texas Intermediate has climbed from about $67 per barrel at the end of February before the US and Israel launched their strikes on Iran, triggering Iran’s counterattacks.
Price Impact
The leap in crude could push consumer price increases in Europe toward 2.3% by year-end, from below 2% currently, a move that is unlikely to justify a tightening bias from the ECB, Shah said.
In the US, Shah expects Treasury yields to rise further as expectations for Fed easing remain “stretched” even after investors scaled back bets from three cuts this year to fewer than two. The benchmark 10-year yield rose by 20 basis points last week, the most since President Donald Trump’s announcement of steep tariffs in April.
Even before the conflict in Iran escalated this month, Shah had argued that investors were underestimating inflation risks in the US, where he said resilient economic growth, tariffs and fiscal stimulus have put pressure on consumer prices.
“The adjustment higher in yields is something I have been calling for in recent weeks and is justified by the fundamentals, and I expect it to continue,” he said.
Shah also cautioned investors against taking the opposite side of recent market moves as some popular positions have begun to unwind.
The risk, he warned, is that the vital Strait of Hormuz remains effectively shut, disrupting the flow of oil and refined petroleum products, which would be “extremely damaging” to the global economy. Iran’s use of cheap but lethal drones to attack neighboring countries and target commercial vessels heightened the risk that the conflict could drag on, he said.
“Markets are not (yet) pricing this risk fully,” he wrote.
Written by: Ye Xie @Bloomberg
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