Oil and rates

Our thoughts are with all those affected by the grim conflict in the Middle East, and we can only hope for a speedy end to it. It feels insensitive in the circumstances to talk of oil and interest rates. Inevitably, too, our view is blurred by the media lens, making it difficult to hold onto the long-term, impersonal perspective needed in the narrow, economic context.

The backdrop of shocking news and loaded commentary makes it easy to imagine worse-case potential outcomes. As investment advisers, we have to remember that others exist, even now. While conflict continues, however, oil and gas supplies are constrained, and prices are being squeezed higher.

Perversely, an immediate effect may be higher corporate earnings. The oil sector itself, despite disrupted supply, benefits from higher prices, and there are few big direct users of oil in the main stock indices. However, what matters more to stock prices is the potentially harmful effect on consumers' spending power. This threat to economic growth is pulling the big stock indices lower (albeit not yet dramatically).

Bond prices are also affected. Petrol and related prices have already risen, perhaps in time even to affect consumer price indices for March, and inflation will be higher for a while at least. Shorter-dated inflation-linked bonds get a bigger uplift in prices, while yields on conventional bonds rise to compensate.

However, for the very shortest maturities, yields now imply a material change in central bank policy. In place of further cuts in US and UK rates in 2026, and a "no change" stance in the eurozone, money markets now expect no cuts in the US, and rate increases in the eurozone (two) and UK (three, as we write, after some seemingly hawkish Bank of England comments). Meanwhile, longer duration bonds – particularly in Europe – have been hit still harder, as implied longer-term "breakeven" inflation expectations have also risen.

We are a little surprised at the scale of this rethink on policy, and by the sell-off in longer dated bonds in particular, because of that likely deflationary effect from weakened economic growth. If unemployment rises, for example, wages will be softer, muting any follow-through from the initial inflation spike.

Traditionally, central banks would often "look through" what is primarily a one-off shock rather than an ongoing inflationary wave. Inflation targets are often couched in terms of "underlying" (ex-energy and food) rather than "headline" consumer prices.

Perhaps central banks – especially the Bank of England – have been sensitised by their post-pandemic mistake, when they erred on the side of laxity and let underlying inflation push above target (even before Russia's invasion of Ukraine caused energy prices to spike, by which time interest rates had belatedly started to normalise). Or perhaps they will want to dampen those longer-dated breakeven rates, to stop higher inflation expectations becoming ingrained.

It seems too soon to bet on policy responding so hawkishly. Yes, energy constraints do widen the gap between effective aggregate demand and supply – but not for long: the eventual hit to the latter, as consumer demand begins to fade, is a sort of automatic stabiliser.

We wouldn't make too much of this. After all, we started the year feeling that the room for interest rates to fall was not as great as the money markets then seemed to believe, and we usually worry more about inflation than its opposite. Our earlier concerns have arguably now been priced in – just not for the reasons we thought.

It does mean, though, that from here we see stocks (and credit) as more vulnerable than bonds. And stocks looked expensive to begin with, while longer-dated bonds didn't.

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