The conflict in the Middle East and the surge in oil prices suddenly cast an unusual amount of uncertainty around the outlook for inflation and monetary policy across most major central banks. Federal Reserve officials signaled a broadly cautious stance as inflation remains above target and geopolitical risks add uncertainty to the outlook. Several officials, including regional presidents, warned against complacency and highlighted persistent price pressures in services and sectors such as healthcare. The surge in oil prices following US and Israeli strikes on Iran has further complicated the outlook, with some policymakers noting that prolonged energy shocks could delay easing. Minneapolis Fed President Neel Kashkari said the conflict makes him less certain about a rate cut this year, while Richmond Fed President Tom Barkin stressed the need to assess whether the shock proves temporary or persistent.

ECB officials also struck a measured tone as the Middle East conflict drives energy-price volatility and clouds the euro-area outlook. Several of them warned that sustained increases in energy costs could trigger second-round effects on inflation but stressed that temporary price swings should not prompt immediate action. Markets have begun to price the possibility of a rate hike later this year, though ECB President Christine Lagarde and colleagues stressed that decisions will remain data dependent.

A similar approach was mentioned by Bank of England policymaker Alan Taylor who urged central banks not to overreact to energy-price shocks, arguing that monetary policy cannot fully offset such supply-driven spikes. He emphasized that policymakers should focus on underlying inflation trends rather than temporary price swings and warned that the UK’s economic backdrop remains fragile, suggesting prolonged tight policy could eventually weaken demand.

Central banks appear unlikely to react immediately to the recent developments in oil prices, waiting for more clarity on the length of the conflict and of higher energy prices, and the impact on inflation and growth before possibly altering their views. In the meantime, market expectations around monetary policy will likely remain volatile in the near future. 

Credit

The magnitude of the credit spread moves, especially in investment grade (IG), was modest compared to TTF gas price and oil prices last week. Oil price increased by 34% higher and TTF rose +56%. EUR IG spreads widened by only one basis point last week, while USD IG spreads even tightened by one basis point. However, total returns were negative across all credit segments as US Treasury and Bund yields rose materially. Both US IG and EUR IG declined by 1.1%, US high yield (HY) fell 1.0%, and EUR HY fell dropped 1.3%.

Within EUR IG, the utility and insurance sectors outperformed. In EUR HY, the communication sector delivered the smallest total return loss. In USD IG, insurance sector underperformed, reflecting concerns about their exposure to private credit. In practice, US insurers’ direct exposure remains low, while Europe’s aggregate exposure is even smaller and typically well diversified. At this stage, only EUR High yield appears to have meaningfully priced a near-term energy shock. Lower-rated European companies tend to be more energy intensive.

Fund flows are the closest real time indicator of investor demand in the credit markets. EUR IG recorded a small net inflow, but long-term EUR IG funds experienced another week of outflows. Investors favour short- and medium-term duration segments of the market. US IG and US HY recorded a small inflow. Meanwhile, pan-European HY recorded its largest weekly outflows this year.

Should disruptions persist for several weeks, credit spreads could widen further. Europe is particularly exposed to the energy shock, while shortage of nitrogen fertiliser could affect food inflation globally.