Rates Spark: Waiting for oil prices to come down
Rate markets welcome the prospect of the Middle-East conflict ending, but remain on edge as oil prices still trade high. A tail risk scenario whereby oil turns higher from here and stays there for a prolonged period could lead to lower 10Y rates. We have already seen that long-term inflation expectations do not fully track movements in oil prices
Energy prices will still need to ease lower for a clear rates outlook
Markets are welcoming the thought of the Middle East conflict ending soon, but oil prices tell us that we’re not there yet. We still have European Central Bank hikes priced in for 2026, and whilst equities made a push higher, the VIX continues to point towards fragile risk sentiment.
Our outlook for rates from here depends on the path of energy prices. A further drop in energy prices should price out the chance of ECB hikes, pulling 2Y rates lower again. An improvement in risk sentiment could mean that 10Y rates remain sticky at current levels.
If, on the other hand, energy prices stay higher for longer, the picture turns more complex, and much will depend on the growth outlook. A tail risk scenario whereby energy prices rise materially from here and stay high for many months could see the ECB forced to hike rates. The immediate effect of higher inflation and policy rates would push up the euro swap curve. But the risk is that the growth outlook turns more negative due to higher energy costs and tighter monetary policy. In response, markets could actually start pricing in significantly looser monetary policy after the initial inflation shock. Alongside deteriorating market risk sentiment, such a scenario would bring down longer-dated rates materially.
Over the past few days, the longer-dated inflation forwards have already failed to fully track oil prices higher – while Brent still stood above US$100/bbl, the 5y5y fell below the prior day’s peaks when oil was still closer to US$90, an indication that the market started to shift the focus away from just the inflation narrative.
Wednesday’s events and market views
Eyes will remain on the oil price, with the Wall Street Journal reporting that the IEA proposed the largest ever coordinated release of oil reserves. The main data event of the day is the publication of the US CPI for February. While the market is focused on the energy story, the February print could point to lingering upward pressure from tariffs on goods prices (consensus sees a 0.2% month-on-month for core CPI). Markets might be nudged to price a more cautious Fed when it comes to rate cuts. Another data point of interest is the federal budget balance for February.
Things are quieter on the eurozone side, with final inflation prints from Germany and Spanish retail sales the only notable releases. The ECB’s de Guindos is participating in a fireside chat in the morning, while Schnabel is slated to speak in the afternoon. Overnight, ECB officials reiterated that the ECB will not allow inflation to set in as in 2022/23, but called for calm and avoiding haste in the crisis (Villeroy). The ECB would not “jump” to a conclusion (Lagarde).
Broader primary markets have reopened. The EU sold its new 10Y benchmark and deal announcements, such as Amazon’s, made headlines. In European government bond markets on Wednesday, Germany will auction 10Y Bunds (€5bn) while Portugal sells 8y and 10Y bonds (up to €1.5bn). The US will later sell 10Y notes (US$39bn).
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