Investors bet central banks will respond to oil shock with rate rises

Investors are betting that central bankers could be forced to raise interest rates in response to the Iran war, as an energy price shock triggers a dramatic reassessment of previous expectations for further cuts.

The European Central Bank is now expected to lift its key rate once or twice this year as soaring oil and gas prices reignite inflationary pressures, according to levels implied by swaps contracts. A rate increase from the Bank of England is also viewed as a possibility by the end of the year, a sharp turnaround from the rate cuts priced in before the conflict broke out.

Investors have also started dialling back expectations for further US Federal Reserve rate reductions, with just one or two quarter-point cuts priced into futures markets, down from two or three before the conflict began. 

Those bets reflect a belief that policymakers have learnt bitter lessons from the inflationary surge that followed Russia’s full-scale invasion of Ukraine in 2022, when most central banks were seen as far too slow to respond to rising prices. 

“We are seeing a global repricing of risk,” said Frederik Ducrozet, head of macroeconomic research at Pictet Wealth Management. “Bond markets woke up this morning to the possibility that oil prices might not rise to $100 [a barrel] but to $150 or even $200.”

Central bankers’ traditional playbooks suggest they can sit tight and “look through” big surges in the oil price, as they bet that higher costs will ultimately bear down on consumer demand and damp the longer-term inflationary implications. 

But policymakers were accused of acting too slowly after the energy price rise in 2022, meaning they are likely to be more aggressive as they seek to quell more persistent inflationary pressures, analysts warned. 

“Central banks are haunted by the experience of the past few years — they wish with hindsight they had acted more promptly in the face of rising inflation expectations,” said Michael Saunders, economic adviser to Oxford Economics and a former BoE rate setter. 

“I assume they have basically learnt that lesson, and rather than waiting for second-round effects to appear, which is what they did last time, they will assume these will appear and start to either tighten or loosen less than otherwise.” 

For now, ECB policymakers are warning about the inflationary implications of an extended conflict but have not suggested that an immediate response is imminent.

Philip Lane, the ECB’s chief economist, said last week that a prolonged war in the Middle East and a persistent fall in oil and gas supplies from the region could cause a “substantial spike” in inflation and a “sharp drop in output” in the Eurozone. 

Deutsche Bank analyst Henry Allen wrote in a note to clients on Monday that “officials aren’t signalling a shift and there’s been no policy adjustment yet”.

Karsten Junius, economist at J Safra Sarasin, said that rate-rise expectations were “overshooting” at the moment. He pointed to the fact that the ECB is at present forecasting six quarters of inflation below its 2 per cent target until the end of next year, which leaves some leeway for faster price rises.

Should the war in the Middle East result in a 15 per cent increase in oil prices this year, it would lift euro area inflation by 0.25 percentage points to 2.1 per cent — a level that was still “entirely in line” with the ECB’s medium-term 2 per cent target, Junius said.

Before the US and Israel launched their attacks on Iran, investors were betting on two more rate reductions by the BoE this year, with another downward move priced in as soon as next week’s meeting. 

Markets now see a roughly 30 per cent chance that the BoE will lift rates this year from the current 3.75 per cent level. 

The swing in swaps markets has hammered the value of short-term sovereign debt, with two-year gilt yields up more than 0.5 percentage points since the conflict began to about 4.1 per cent.

Some investors expect the bank to be reluctant to increase interest rates during an energy shock that hurts growth and pushes up prices. The UK labour market is already weakening and the economy barely grew at the end of last year.

“The [UK] economy could plausibly enter a short recession,” said Tomasz Wieladek, chief European macro strategist at T Rowe Price. “The Bank of England is aware of that and will therefore likely keep rates on hold rather than outright hike at this stage.”

But at 3 per cent, UK inflation remains well above the BoE’s 2 per cent target level. While household inflation expectations have receded, the public was expecting consumer price growth of 3.3 per cent in the coming year even before the Iran war, according to a monthly survey from YouGov for Citigroup. 

The BoE was heavily criticised for being slow in responding to the burst of inflation that began in 2021, driven initially by the after-effects of the pandemic and then by rising commodity prices as the Ukraine war disrupted supplies. The view that this would be “transitory” turned out to be misguided as inflation went on to peak above 11 per cent in the autumn of 2022. 

The BoE has been overhauling its forecasting and communications, informed in part by an excoriating report by former Fed chair Ben Bernanke in 2024, placing greater emphasis on how it might react to potential “scenarios” and less on its central forecast. 

The fallout of the Middle East is affecting a widening range of central banks. Only a few months ago, traders were betting that the Swiss National Bank, whose benchmark interest rate sits at zero per cent, could push that below zero to deal with its soaring currency.

But now one or two quarter-point increases are expected this year. That shift in expectations has dragged Switzerland’s two-year bond yields back into positive territory.

The Bank of Canada, which was viewed as more likely to cut before the Middle East conflict kicked off, is also expected to make one or two quarter-point increases by the end of the year, according to swaps contracts.

Pictet’s Ducrozet stressed that the “key variable to watch” for the ECB would be inflation expectations, pointing to board member Isabel Schnabel’s speech on Friday when she stressed that “central banks should focus on anchoring expectations rather than trying to fine-tune economic activity”.

“I think and hope [the ECB] will just do nothing”, he said. However, he added that “nothing can be ruled out at this stage” as the ECB was still suffering from “significant trauma from the previous inflation shock”. 

Data visualisation by Ray Douglas