Markets shifting policy pricing amid ongoing energy shock

The Federal Reserve, European Central Bank (ECB), Bank of Japan (BoJ), Bank of England (BoE), and Bank of Canada (BoC) all meet this week.

Sweden's Riksbank, the Swiss National Bank, and the Reserve Bank of Australia also convene.

The backdrop for these policy meetings is one of elevated geopolitical uncertainty, upside risk to headline inflation rates from rising oil prices, and core inflation rates that generally remain above central bank targets.

Geopolitical uncertainty, which intensified over the last week, is often difficult for central banks to navigate.

With respect to the current events, rising oil prices put upward pressure on inflation but can also provide a headwind to growth.

Unlike the Federal Reserve's maximum employment mandate, most central banks do not have explicit growth objectives.

However, policymakers tend not to disregard developments related to the real economy.

This creates a challenge when circumstances cause growth and inflation to pull monetary policy in opposing directions.

History offers a clear lesson.

In the 1970s, central banks eased policy in response to oil-driven shocks.

Just prior to the 1973 oil embargo, the inflation-adjusted fed funds rate was 2.2%, and the real BoE bank rate was 2.1%.

One year later, these real policy rates declined to negative 2%.

Because central banks accommodated the rise in oil prices, these higher prices fed into underlying inflation.

U.S. CPI excluding Energy—already elevated at 6.7% in the third quarter of 1973—rose sharply to 11.2% in the fourth quarter of 1974.

The monetary policy response to rising oil prices in the 1970s is widely judged as misguided.

Today, central banks face a similar challenge but from a different starting point.

Core inflation already exceeds central bank targets in most major economies prior to the conflict.

U.S. core Personal Consumption Expenditures (PCE) inflation was reported last week at 3.1% year-over-year for January, Eurozone core Consumer Price Index (CPI) was 2.4% in February, and U.K. core CPI was 3.1% in January—the Fed, ECB, and BoE all target 2% inflation.

Given above-target inflation and an upside risk to prices, markets have repriced expectations for policy rates.

Interest rate futures are priced for only 25 basis points of Fed rate cuts by December versus 61 basis points of cuts prior to the conflict.

The ECB is priced for 41 basis points of rate hikes now versus 14 basis points of cuts at the end of February, while the implied BoE bank rate or December rose to 3.90% from 3.20%.

Bottom line: Inflation was already sticky prior to the conflict.

Recent developments add upside risk and have pushed expected policy rates higher.

Policymakers will likely remain in wait-and-see mode until there is greater clarity on the duration of the conflict and its impact on growth and inflation.

Markets began the week pricing a more de-escalatory path for the conflict between the U.S., Israel, and Iran.

Oil prices and longer-term yields have eased, supporting a rebound in equities.

Despite the year-to-date rotation favoring small caps over large and non-U.S. over U.S. in performance, the Monday bounce can be found across both legs of the rotation.

As previously discussed, investors continue to bid U.S. assets during this period of stress despite ongoing AI-disruption and private credit fears.

We view this as a positive sentiment indicator for U.S. assets, particularly around the U.S. economy's more favorable energy position as an exporter of both oil and natural gas relative to the energy-importer position of other developed and emerging market economies (Europe, Japan, etc.).

We believe the backdrop for global equities remains constructive in the event of a near-term resolution.

The well-behaved nature of risk assets amid the multitude of headlines reflects this view.

However, we continue to express humility around the conflict's trajectory from here.

Disruptions to the energy supply chains may persist for some time beyond any U.S. declaration of victory given the differing stances of both Israel and Iran at that point.

The odds of demand destruction from higher energy prices increases the longer the Strait of Hormuz remains compromised, and the full reopening is challenging to forecast.

In this environment, investors should remain focused on long-term positioning rather than attempting to trade short-term market moves.

Bottom line: Current market resilience reflects optimism around a near-term resolution.

This outcome would support risk assets and reinforce a constructive macro backdrop.

However, conditions can shift quickly, and we continue to emphasize long-term discipline as the conflict evolves.

In December, we highlighted that our positive macro outlook entering a cyclical inflection point combined with bottlenecks related to the AI capex boom required investors to incorporate natural resources-oriented expressions into portfolios.

Energy equities featured prominently in that recommendation as investor flows began rotating toward cyclical assets.

With geopolitical risk largely driving the recent crude rally, the duration and trajectory of the conflict have become central questions for investors positioning for what comes next.

Importantly, the absence of a durable (i.e., longer than 12-month) shift in oil supply-demand fundamentals reinforces the need for disciplined risk management around energy complex exposures—particularly during sharp, sentiment-driven moves such as the one currently unfolding across oil and energy equities.

Crude oil remains above $90 to start the week and up over 40% since the Iran conflict began, while U.S. Energy equities are following suit with a +2 to +3 standard deviation move across 5-year z-scores for most valuation metrics (see Figure 1).

The rolling 65-day Sharpe ratio of U.S. Energy equities also breached a +3.5 level, a move consistent with relative underperformance over the next three months based on historical data.

Meanwhile, analysts have only revised up earnings estimates for U.S. energy companies by 1.4% over the last week, reflecting the uncertainty for fundamentals around supply shocks as they can quickly turn into a situation of demand destruction and falling oil prices as supply comes back online.

On this risk and dramatic outperformance of Energy since December, we see this as an opportunistic time to close our tactical trade in the sector.

Bottom line: Energy prices may remain elevated in the near term, but uncertainty around the duration of the Iran conflicts limits upside.

Given the crosscurrents impacting fundamentals, we view this as a potential opportunity to consider exiting our tactical Energy equity exposure established in December.