Original Author: Zhao Ying
Original Source: Wall Street News Agency
Global markets are simultaneously betting on strong growth, limited rate hikes, controllable energy supply shocks, and a decline in oil prices. This "Goldilocks" combination appears favorable for risk assets but leaves little room for error concerning policy, inflation, and geopolitical developments.
Deutsche Bank macro strategist Henry Allen pointed out in a recent report that US stocks at record highs and credit spreads at low levels reflect investors' belief that economic growth remains resilient; however, the interest rate market is pricing in fairly limited subsequent rate hikes by the Federal Reserve. This suggests that if inflation does not cool as expected, or growth continues to exceed expectations, the market may need to rapidly reassess the path of monetary policy.
Similarly, divergence exists in energy markets. Although Brent crude prices have retreated significantly from recent highs, the Strait of Hormuz has not yet returned to normal traffic, and no agreement to restart full passage has been reached. There remains a gap between the expectations of supply recovery reflected by oil prices and the forward curve, and the actual logistics and infrastructure risks.
For investors, the key lies not in the current growth or oil price itself, but in whether multiple optimistic assumptions can hold true simultaneously. Deutsche Bank warns that if strong growth pushes up inflation pressure, or energy supply disruptions persist, the existing pricing relationships between risk assets, interest rates, and inflation expectations could all be broken.
The Pricing Contradiction of Strong Growth and Moderate Rate Hikes
The signals from US risk assets remain optimistic. The S&P 500 hit another record high last Friday, corporate earnings growth remains strong, and credit spreads are at low levels. The Atlanta Fed's GDPNow model estimates that the US economy's annualized growth rate in the third quarter could reach 5.8%.
Financial conditions also remain relatively loose. The Bloomberg US Financial Conditions Index rose last Friday to its loosest level since 1997, and the July unemployment rate fell to 4.1%, a 13-month low. These indicators together suggest continued resilience in economic activity.
However, the pricing in the interest rate market does not fully match this growth picture. The June US PCE inflation rate was 3.7%, still above the policy target, yet federal funds rate futures only price in about 31 basis points of hikes by the Fed's December meeting, with a cumulative peak of only about 47 basis points by June next year.
Deutsche Bank believes that the market is currently pricing in strong economic growth, loose financial conditions, inflation above target, and only moderate Fed rate hikes—a combination that is difficult to sustain in the long term. Adjustments could come from a rapid fall in inflation, a weakening of risk assets, or the Fed adopting a more hawkish policy path than the market expects.
Historical Trends Suggest the Fed May Tighten More Than Expected
Henry Allen points out that over the past 70 years, there has been a strong correlation between the level of inflation when the Fed starts raising rates and the magnitude of its rate hikes in the first year. Based on the current CPI inflation rate of 3.5%, the corresponding first-year tightening magnitude suggested by historical trends exceeds 100 basis points, even if inflation eases somewhat by year-end.
In contrast, the less than 50 basis points of cumulative hikes priced by current futures markets is significantly lower than the level implied by historical experience. Deutsche Bank believes that if both economic growth and inflation remain resilient, the market may be underestimating the possibility of the Fed pivoting to a more aggressive stance.
The experience of 2022 provides a reference. Back then, the market initially expected a relatively mild hiking cycle, and the Fed also began with 25 basis point hikes, but later increased the size of single hikes to 75 basis points, accumulating 450 basis points of hikes within the first 12 months and 525 basis points for the entire cycle.
The report also notes that scenarios involving "one hike followed by a prolonged pause" have been relatively rare in history. Since the 21st century, 2015 was one of the few cases, where the second hike came a full year later, mainly due to weakening economic data and concerns about a broader slowdown.
Divergence Between Oil Price Pricing and Geopolitical Reality
The decline in oil prices is an important basis for the market's optimistic pricing, but Deutsche Bank believes this price performance is not entirely consistent with supply realities.
Brent crude is currently around $88 per barrel, below the level of over $100 per barrel three weeks ago and significantly lower than the intraday high of over $120 per barrel in April. However, the Strait of Hormuz remains obstructed, with no agreement yet to restore normal traffic, and the volume of passage through the Strait is still far from pre-conflict levels.
At the same time, risks to energy infrastructure persist. Houthi forces claimed to have attacked Saudi Arabia's Jazan refinery over the weekend, further highlighting the uncertainty facing the crude oil supply chain.
Despite this, the market continues to price in a supply recovery. The price of 12-month Brent crude futures is more than $10 per barrel lower than the near-month contract, reflecting widespread investor expectations that oil prices will decline in the future. Deutsche Bank believes this expectation is highly dependent on the eventual restoration of normal traffic through the Strait of Hormuz, a development that has yet to materialize.
Supply Chain Shocks and Inflation Risks Are Underestimated
This year, energy markets have experienced some of the most severe volatility since 2022. In July alone, Brent crude surged nearly $30 per barrel within three weeks, briefly returning above $100 per barrel, before retreating significantly. Year-to-date, Brent crude is still up over 40%.
European natural gas prices are also at relatively high levels for the year. Deutsche Bank believes that volatility in energy prices indicates that supply shocks have not disappeared, and the overall market pricing of inflation risks remains relatively mild.
Potential pressures include the continued obstruction of the Strait of Hormuz, tariffs remaining a part of the global economic environment, and the possible occurrence of a strong El Niño phenomenon this year. If food and energy prices remain under pressure, inflation expectations could rise, increasing the risk of a wage-price spiral.
This means that even if oil prices temporarily remain below recent peaks, the path of inflation decline may be more tortuous than the market expects. For central banks, energy and supply-side risks may limit their room for a rapid pivot to easing.
Equities, Inflation, and Interest Rate Markets Are Not Sending Consistent Signals
Since the Iranian conflict began in late February, equities, credit markets, and inflation swaps have shown relatively high sensitivity to changes in oil prices. In mid-to-late July, as Brent crude rebounded above $100 per barrel, the stock market experienced a pullback; after entering August, oil prices retreated, and risk assets subsequently rallied, pushing stock indices to new highs.
Short-term inflation expectations also largely followed a similar trajectory, declining significantly as oil prices fell. However, the reaction in the interest rate market was not entirely consistent. Even as equities rebounded and oil prices fell, bond yields continued to rise and hit new highs.
Deutsche Bank believes that some of these moves may be related to recent Fed meetings, strong global economic data, and a recovery in risk appetite, but the macro views reflected by different asset classes still conflict. The equity and credit markets are closer to a scenario of "resilient growth, controllable oil prices," while the interest rate market still seems to be pricing in the long-term effects of geopolitical conflicts and energy shocks.
The Perfect Scenario Depends on Multiple Conditions Being Met Simultaneously
Deutsche Bank believes that for the current pricing to be validated, supply-driven economic growth, falling inflation, easing geopolitical risks, and the restoration of normal traffic through the Strait of Hormuz need to occur simultaneously. Such a combination would be favorable for corporate earnings and stock performance and would also reduce the necessity for central banks to adopt aggressive tightening policies.
Productivity growth driven by artificial intelligence could provide a supportive factor for supply improvement. However, the report notes that recent price performance in areas such as memory chips also shows that AI demand itself may bring new inflationary pressures.
Therefore, the core risk facing the market is not a single variable going out of control, but the possibility that multiple optimistic assumptions fail to hold true simultaneously. If the economy remains strong and financial conditions continue to loosen, while inflation stays above target, pressure on central banks to raise rates will increase; if energy supply shocks persist, the basis for falling inflation and declining oil prices will be weakened.
In Deutsche Bank's view, the current market is not devoid of positive factors, but rather leaves too little margin for error regarding positive outcomes. Any deviation of a condition from expectations may force investors to reassess the pricing of growth, interest rates, and risk assets.
