Bonds Follow Oil

MACRO FRAME

Global markets are focused on US-Iran talks to reopen the Strait of Hormuz. The renewed negotiations between the two countries offers markets a test to distinguish between positive negotiations, or a durable de-escalation. Whether tankers can begin to move freely will be the penultimate factor in restoring optimism.

STOCK INDEX FUTURES

Equity index futures rose overnight as risk sentiment remains supported by the US and Iran’s outline agreement to extend their ceasefire. Both sides have agreed to a 60-day memorandum of understanding to extend the truce and open negotiations on Iran’s nuclear program, according to a Thursday report from Axios. The agreement still requires President Trump’s formal sign-off. Despite the geopolitical backdrop, oil’s influence on equity markets has diminished considerably. The dominant countervailing force has been artificial intelligence, which has driven strong gains across chip stocks and materially lifted profit and earnings forecasts. With corporate fundamentals improving since the conflict began, the strategic significance of the Strait of Hormuz has receded in the eyes of equity investors.

Market participants, however, remain on edge around deal flow. Traders are on edge with the back and forth on deal news, and have been biased long to avoid getting trampled by any news of a better-than-expected outcome. The harder part is that the inflationary forces may not abate as fast as markets want. Earnings growth and estimates have continued to outpace a lot of those concerns, while the divergence between equities and rates continues to loom in the background for traders.

Watch point: Details regarding tanker traffic through the Strait will be a catalyst for global markets and may significantly reprice expectations over Fed policy.

CURRENCY FUTURES

US DOLLAR: The USD index is little changed at 99.06 following a wave of eurozone inflation readings that came in above target. The dollar is heading for a small loss on the week, as optimism over a US-Iran deal has unwound some defensive long positions in the dollar. Sources said that both countries had reached an agreement to extend their ceasefire and lift restrictions on shipping through the Strait of Hormuz. Despite April’s PCE data coming in below expectations, the reading is still sat at nearly 4% YoY, too high for the Fed to begin thinking about cutting rates, which should offer the dollar some support in the face of risk-on flows away from the dollar. Still, traders await a comprehensive peace deal and restoration of oil flows through the Strait, which could seriously unwind flight-to-quality longs and see the dollar drop substantially. Underlying fundamentals remain mildly supportive of the dollar given the inflationary backdrop and recent statements from FOMC members, which have become increasingly hawkish in recent days and weeks, which in part has been responsible for the hawkish shift in Fed policy expectations. Odds of a December rate hike are at 43%. Expectations of a reopening of the Strait have eased some inflationary concerns among market participants in recent days despite the flareups.

Watch point: Optimism over a formal US-Iran deal will unwind flight-to-quality longs, and reduce tightening expectations, ultimately weighing on the dollar.

EURO: The euro is little changed at $1.1645 following a wave of inflation readings. The EU-harmonised annual inflation rate in Germany fell to 2.7% in May from 2.9% in April, below forecasts of 2.8%. In France, inflation rose to 2.8% from 2.5% but was below forecasts of 2.9%. In Spain, inflation edged up to 3.6% from 3.5% as expected, while in Italy it rose more to 3.3% from 2.8%. Market expectations over European Central Bank policy were largely unchanged following the releases, signaling that the readings were mostly priced in and that traders have reaffirmed their belief in policy trajectory.

Money markets are placing an 93% chance of a hike at the June meeting and see 57 bps of tightening by year-end, largely unchanged over the past week, though down from expectations of nearly 75 bps two weeks ago. For the euro, broader risk sentiment will continue to determine price direction, while the interest rate differential against the dollar remains unfavorable given the recent shift in Fed expectations.

Watch point: While a June rate hike remains the favorable move from the ECB, a peace deal and restoration of oil flows through the strait is likely to reduce  tightening expectations.

BRITISH POUND: Sterling is 0.07% lower to $1.3436 as investors remained cautious over the potential US-Iran deal, while comments from Bank of England Governor Andrew Bailey suggested that the central bank has no immediate desire to move on policy. Bailey said allowing inflation to run above the BoE’s 2% target was justified given uncertainty over the economic impact of the Iran war and the weak pace of growth, signaling policymakers can afford to wait before making any rate moves. Money markets are pricing just a 6% chance of a hike at its June meeting and see 33 bps of tightening by year-end, which is substantially lower than market-pricing two weeks ago, but still rests above our base case. While the UK remains under the cloud of uncertainty related to political leadership, statements from PM front-runner Andy Burnham that he would stick to the UK’s fiscal rules, have calmed currency markets and relieved pressure the Sterling. However

JAPANESE YEN: The yen is little changed against the dollar at 159.26 yen per dollar, remaining near the 160 level, which has previously brought intervention from government authorities. Data on Friday also showed annual core inflation in Japan’s capital stayed below the central bank’s 2% target for a fourth straight month in May, while factory output rebounded in April. Still, it is unlikely that the Tokyo inflation reading will deter Bank of Japan policymakers from wanting to raise rates at their June meeting. Money markets continue to favor a rate hike at the bank’s June meeting, with odds priced at 73%, while the market sees a total of 41 bps of tightening by year-end. Bank of Japan Governor  Ueda struck a hawkish tone on Wednesday, saying the war-driven oil shock could become persistent in an environment of high inflation expectations and rising wages.

Watch point: Given the current status quo, the yen is likely to consolidate in the 157-159 range, unless policy support from the BoJ firms.

AUSTRALIAN DOLLAR: The Aussie is 0.21% higher to $0.7180 as risk sentiment rose overnight over the possible US-Iran deal. Recent data showed that household spending slid a 1.1% in April as consumers cut back on travel, clothing, and food amid the conflict in the Middle East. However, business investment grew 6.5% in Q1. Still, for the Reserve Bank of Australia, the fall in spending suggests that higher interest rates are helping to curb demand and reducing inflationary pressures, though given the conflict, it remains yet to be seen whether or not this is confidence driven or as a result of monetary policy. CPI data on Wednesday missed expectations, with prices in April rising 0.4% MoM, below forecasts for 0.6%. Annual  inflation slowed to 4.2% from 4.6%, though that was in part because of government tax break on petrol. However, the key trimmed mean measure of core inflation rose 0.3% as expected, taking the annual pace up to 3.4%, which is likely to keep the Reserve Bank of Australia on its tightening bias. Markets have slashed tightening expectations, implying a 7% chance of a June hike to the 4.35% cash rate, while a December hike has fallen from being fully priced in just a 56% chance.

Watch point: While a durable end to the war would alleviate downside risks to growth and moderate inflation pressures, ongoing pass-through into broader prices is likely to keep the RBA on a tightening path.

TREASURY FUTURES

Yields are little changed across the curve in reaction to this morning’s PCE data. Treasury markets continue to take directional cues from oil prices, as a sustained move higher in crude would carry the greatest risk of re-anchoring embedded inflation expectations at elevated levels. The 10-year yield has tracked the trajectory of December Brent crude closely over recent months, though there are emerging signs that this correlation is beginning to soften. On the labor market front, the Chicago Fed’s Real-Time Unemployment Rate Forecast for May stands at 4.32%, edging down from the prior BLS reading of 4.34%. The modest improvement is largely attributable to a slight decline in separations, as reflected in the Chicago Fed’s Layoffs and Other Separations Rate.

Downside risk for bonds remains Iranian opposition to peace talks and a continuation of stalled traffic in the Hormuz. Two-year yields continue to hold well above the upper bound of the Fed Funds rate, reinforcing market expectations of a Fed that has shifted to the hawkish side. Fed Governor Waller said it is “crazy” to talk about rate cuts given current inflation, and explicitly stated he “can no longer rule out rate hikes further down the road if inflation does not abate soon.” Given that the median and trimmed mean inflation readings both sit above 3%, while the Fed’s supercore measure also sits over 3%, it is unlikely that the Fed will move on policy in 2026. Yields appear to be adjusting as if the Fed is behind the curve, ultimately supporting a view that bonds are likely to remain under moderate pressure and consolidate rather than sustain a durable rally.

Watch point: The path to loosening has appears nonexistent as inflation has evidently become more broad based. We no longer expect the Fed to lower rates in 2026 as building inflationary pressures are evident in stickier readings.

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