Oil Prices and Inflation: Will the Iran War Kill Fed Rate Cuts?

Will the stock market finally break lower as the US-Iran war stokes inflation, sinking Fed rate cut hopes?

• Stocks remain stuck in consolidation despite geopolitical turmoil
• Crude oil surge after US-Israel strike on Iran raises inflation risks
• ISM service sector PMI survey in focus to gauge price pressures

Stock markets continue to seesaw as investors weigh whether the biggest threat from the US-Israel strike on Iran is instability linked to the geopolitical conflict itself or the inflation shock that may follow from surging crude oil prices.

The bellwether S&P 500 stock index attempted to break lower Tuesday but ultimately ended the day back in the middle of its recent consolidation range. That follows a now-familiar pattern: stock index futures gapped lower at the weekly trading open as traders reacted to the start of the US-Iran war, then snapped higher amid hopes for a limited engagement, only to lose momentum again. For now, traders seem unable to commit one way or another.

Price action elsewhere in the markets may be more revealing. 

Gold posted a sharp decline despite churning geopolitical risk. It fell 4.39%, the most in a month. That seems unusual: the metal typically benefits from such instability. Investors find understandable appeal in a non-sovereign store of value when governments and financial systems are at risk of becoming entangled in conflict.

Meanwhile, Treasury bonds sold off while the US dollar rallied strongly for a second consecutive session. The greenback added 0.58% against an average of its major currency counterparts, closing at the highest level in six weeks.

US-Iran war: inflation fears taking center stage for markets?

Taken together, the combination of lower gold and bonds alongside a stronger dollar suggests markets may be increasingly focused on inflation and interest rate expectations rather than purely on geopolitical risk.

Crude oil appears to be the key transmission channel.

Prices have understandably surged since hostilities began and now appear to be breaking above a downtrend that had guided them since the second half of 2023. This week’s rally builds on a move already underway earlier this year as a popular uprising in Iran, enhanced enforcement against Russia’s so-called “shadow fleet” oil tankers, and US action in Venezuela began to cast doubt on expectations of a global supply glut.

China sits at the center of the story. As the world’s largest crude oil importer, it has relied heavily on discounted barrels from Russia, Iran and Venezuela. Disruptions to those flows could force Beijing to source more oil from producers such as Saudi Arabia, Iraq or Brazil at market prices, tightening inventories that were not positioned for the shift.

The inflation implications could follow quickly. Historically, moves in crude oil can take about a month to filter into headline US consumer price index (CPI) inflation readings. That is a troubling prospect for Federal Reserve policymakers and traders hoping the central bank will get back to cutting interest rates. Price growth is already running above the Fed’s 2% target, and officials have worried aloud about making sure it gets there.

ISM services PMI data: will it help or hurt Fed rate cut hopes?

Recent economic data reinforces these concerns. Purchasing managers index (PMI) figures from the Institute of Supply Management (ISM) showed manufacturing sector activity rebounding strongly, with the first two months of the year marking the fastest pace of expansion since mid-2022. At the same time, the report’s prices-paid component jumped sharply, pointing to mounting cost pressures.

Markets nevertheless continue to price in substantial easing. Traders have priced in 43 basis points (bps) in rate cuts this year and 19bps for 2027. That amounts to a 72% chance of two standard-sized 25bps rate cuts in 2026 and a 76% chance of a third one to follow next year. That amounts to about one more rate cut than Fed officials penciled into their projections in December, and with a faster timeline to delivery.

Hawkish comments from Fed officials so far this year hint this divergence has probably become more pronounced. That seems to have put the brakes on Wall Street. Tellingly, the S&P 500 and the Nasdaq 100 have been mired in a choppy range since late October, when Fed Chair Jerome Powell warned investors against over-extrapolating rate-cut expectations.

The spotlight now turns to the service sector ISM report. It is expected to show that the pace of economic activity remained brisk in February after hitting a 12-month high in December and matching that feat in January. In that month’s report, this translated into the fastest price growth since October. Stock markets may face selling pressure while the dollar continues to build higher if the incoming report continues to point toward reflation.

Ilya Spivak, tastylive head of global macro, has over 15 years of experience in trading strategy, and he specializes in identifying thematic moves in currencies, commodities, interest rates and equities. He hosts Macro Money and co-hosts Overtime, Monday-Thursday. @Ilyaspivak

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