Inflation has been top of mind for investors amid surging oil prices, but Citadel Securities says it might be mostly priced in by now, while the risks to growth might still be underappreciated by markets.
The firm turned more upbeat on Treasurys after the latest war-fueled rout. The 10-year Treasury yield edged lower on Tuesday, but is still up 24 basis points since the Iran war began. The rise has been driven by concerns that inflation could see a resurgence and keep interest rates elevated.
But Citidal Securities’ macro strategist Frank Flight said on Monday that inflation isn’t the biggest risk as the war drags on through the its third week.
“Markets need to see safe passage of international ships through the Strait of Hormuz soon, or financial conditions will need to shift focus from inflation to growth risks,” Flight said, adding that he sees the potential for a bond rally that brings rates lower, and that the firm has turned neutral on US fixed income after having recently been bearish.
Interest rates tend to rise when the threat of inflation increases. But when economic growth prospects begin to sour, they tend to move lower as central banks try to stimulate economic activity by cutting rates, while investors may also pile into bonds seeking shelter amid turmoil in other assets like equities.
Investors are already pricing in the inflation risk from higher oil prices, however, Flight said. What they’re not taking into account is the downside risk to growth that would emerge if the Strait of Hormuz stays closed for an extended period.
That leaves room for downside in stocks, he said, and for corporate bonds to become more expensive relative to Treasurys.
Flight said that if markets begin to price in a more drawn out conflict in which the Strait remains closed, equity and credit markets could “move materially lower as demand destruction emerges in response to expectations of a more prolonged disruption to global oil and trade flows.”
Flight warned that a repricing of growth risks could trigger slower growth by tightening financial conditions, in a kind of self-fulfilling prophecy. This would be exacerbated by the fact that governments are less willing to stimulate their economies through fiscal measures after the 2022 inflation wave.
Citadel Securities’ models illustrate Flight’s argument. The firm’s central bank policy model signals that investors’ expectations for higher rates should soon ease, Flight said.
The growth model, however, shows that investor expectations have effectively stayed the same since the start of the war, meaning there’s more room for downside. Fligth added that the reading “suggests a concerning degree of complacency and implies downside risk to equities and credit.”
Citadel Securities
Earlier this week, Bank of America also issued a note of caution that investors are not pricing in a potential growth slowdown, as consumers could see energy prices eat into spending budgets, and global economies could have less oil to fuel activity.
“The major risk to markets, beyond shipping, remains the possibility of permanent losses of energy production in the Gulf depending on the degree of Iranian retaliation,” the bank said in a client note.
