What our new energy price scenarios mean for markets

The war in the Middle East continues and the Strait of Hormuz is practically blocked. Our initial base case assumptions from our March Monthly regarding the war have become outdated. This is why we have developed three new scenarios, guiding our thinking and macro and markets forecasts. These scenarios are discussed alongside oil and gas price implications in our commodity team’s note. In summary:

Scenario 1 (our new base case): intensive combat will end within the next two weeks but will be followed by lower intensity strikes that linger on for several months. It’s a scenario in which the opening of the Strait of Hormuz will take much longer than initially anticipated. The 'end game' in this scenario could be a temporary ceasefire or tacit stand‑down with maritime escorts and exploratory talks on sanctions. Regime change over time is still possible, driven from the inside, as in East Germany in the late 1980s.

Scenario 2 (optimistic alternative): War ends surprisingly earlier than in our new base case scenario and the Strait of Hormuz opens up within a short period.

Scenario 3 (longer war): Longer combat action followed by protracted lower-grade, impulsive confrontation. That would imply a much more uncertain situation in the Strait. In this scenario, the 'end game' could be a hard‑won ceasefire with third‑party guarantees (likely involving Russia or China) and the possibility of sequenced sanctions relief, plus maritime security regime for Hormuz. However, even then, a durable peace could remain elusive, and the region might settle into a fragile, flare‑up‑prone equilibrium.

The Federal Reserve's position in early 2022 was that inflation was transitory due to a supply shock and higher rates were not needed. However, robust hiring, soaring wage growth, and pent-up demand following the lockdowns – reinforced by stimulus cheques from the government – drove a surge in consumer spending and inflation spiralled higher. The Fed then had to play catch-up, hiking rates by 525bp between March 2022 and July 2023.

Today, the labour market is in a far weaker position, with job creation and real household disposable income stalling over the past six months. At the same time, confidence has been eroded by tariff worries and job security fears, so there isn’t the same demand impetus to fuel inflation. Instead, we suspect that an energy shock risks being demand-destructive through eroding spending power, which ultimately leads to lower core inflation over the medium to longer term.

2026 Inflation would be higher in scenario 1 than scenario 2, but growth and jobs would be weaker, and 2027 inflation would ultimately be lower. As such, we have the same Fed funds forecasts for scenario 1 and 2 due to the central bank optimising policy for its dual mandate of price stability and maximising employment. If there were an equity market correction, as would appear likely in scenario 3, then the demand destruction would be all the greater, leading eventually to a more aggressive Fed response.

While tax refunds are expected to be larger this year (around $4000 on average versus $3200 last year), we would likely need to see a larger fiscal boost, such as stimulus cheques, to generate enough demand that would trigger Federal Reserve rate hikes. Bond markets would likely react nervously, in part due to concern over higher debt levels and partly due to inflation worries. This would ignite talk of a 1970s-style market dynamic, which could be immensely harmful to the economy.

The European Central Bank's approach to oil price shocks has changed over the years – from initially responding directly to rising headline inflation, to focusing on second‑round effects and distinguishing between supply‑ and demand‑driven shocks, and eventually to labelling such price increases as transitory. With hindsight, it is the latter stance that appears to have left some institutional scar tissue within the ECB. Having reacted (too) late to the energy price shock of 2022, the ECB could be inclined to demonstrate its inflation-fighting credentials and decide on pre-emptive rate hikes.

In our new base case scenario, we expect the ECB to hold a heated debate on raising rates but think it will eventually decide to stay on hold. The surge in headline inflation is mainly driven by higher energy prices and second-round effects on food and other product prices. However, these knock-on effects should remain short-lived and milder than in 2022.

Don't forget that in 2022, the energy price shock and supply chain disruptions hit an economy that was emerging from prolonged lockdowns and was willing to pay almost any price for goods and services. Against that backdrop, it is only under our worst‑case scenario that we see the ECB eventually raising rates.

As a consequence of the war to date, we are getting a feed of higher nominal yields, higher real yields and higher inflation breakevens. The 2yr breakeven inflation expectation is now at 3.2%. That’s a market average in the coming two years. At the same time, longer tenor real yields are mostly higher since the war broke out, which is in fact a sign of resilience. The profile ahead is prone to feature higher longer tenor market rates, with the 10yr nominal yield getting to the 4.25% to 4.5% range (now 4.2%), on elevated inflation expectations.

If, as we expect, the war is in a material wind down phase from April onwards and through 2Q, we will be left with a structural elevation in inflation expectations still to deal with (off the highs but still elevated), which will prevent market rates from falling back too much. The 10yr yield does drift back down in the direction of 4%, but remains above that level.

In the “longer war scenario”, real rates collapse lower as risk assets come under material pressure on an elevated recession risk. Here, the 10yr yield breaks back below 4% and gets down to the 3.75% area, or potentially lower (10yr SOFR gets down to c.3.3%). The inflation risk is still material, but the growth angst risk dominates in this more troubling scenario.

Similar to USD rates, the picture turns complex for euro rates when energy prices stay elevated for longer, especially if this forces ECB rate hikes. The immediate impact of higher inflation and policy rates is a push upwards for the entire 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. We see the 10Y swap rate falling back to 2.6%, but that number could very well be lower depending on global risk sentiment and the broader macro outlook.

All our EUR/USD scenarios end up above current spot levels by the end of the year. There are two main reasons for this. First, our expectations are that the shock in oil won’t be matched by a rise in gas prices (read why here). This means a more contained impact on the eurozone terms of trade, which drives EUR/USD medium term fair value. Second, we expect the Fed will go ahead with rate cuts despite the inflationary bump.

However, in the shorter run (2Q), rate differentials should remain a secondary EUR/USD driver relative to oil prices should the latter remain elevated. This is why in our third scenario, we expect EUR/USD to trade back around 1.10 in 2Q before recovering late in the year as the Fed cuts rates aggressively.

Our new baseline scenario sees a roughly 2% downward revision from our pre-conflict 2026 numbers. Downside risks in the near term will persist but expect a return to 1.16 by the end of 2Q and a full resumption of the multi-quarter USD downtrend by the end of the year, with a target of 1.20.

For more details on our latest FX views, we have published our monthly update FX Talking: Same shock, new drill.