Economic and financial risk insights: Middle East conflict adds to economic uncertainty and volatility
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- New war in the Middle East adds to uncertainty created by the lag on the impact of monetary tightening and financial stability risks.
- Upside inflation risks mean we leave our baseline of higher for longer central bank policy rates intact for the Fed and ECB.
- Multi-year high yields in sovereign bond markets add upside risks to our 10y yield forecasts in the short term.
Escalating tension in the Middle East adds to economic uncertainty in an already volatile financial market climate. The flare-up in conflict increases the potential for broader non-linear economic and political fallout. In addition, the latest blowout US monthly jobs report is a reminder that the lags of monetary policy in the labour market may be longer than in other parts of the economy. This and broader ongoing US economic resilience (see Figure 1) extend the upside risks to our short-term forecasts for US GDP growth and terminal Fed policy rate.
Figure 1. Signs of US growth reacceleration
Still, the full impact of "higher for longer" monetary tightening risks precipitating a delayed US slowdown next year. High volatility in bond prices (see Figure 2) and multi-year high yields also mean we see elevated risk of flare-ups in financial instability hurting broad economic sentiment. European economies are showing signs of weakness and we maintain our baseline of stagnation for the region in 2024.
Figure 2. MOVE Index of bond market volatility
Fed, ECB and BoE comments point to rates staying in restrictive territory for a long duration to bring inflation sustainably down to target. US services inflation surprised to the upside in September, but we expect the Fed to hold steady given recent rises in Treasury yields. In Europe, we await the outcome of wage negotiations at year end, with any acceleration in wage growth from current levels calling into question our call that the ECB has reached peak policy rates. In Japan, union wage demands and the latest inflation data may affect the BoJ's unwinding of accommodative monetary policy. Large swings in oil and European gas prices, including since the start of the Israel-Hamas conflict, may also delay global disinflation (see Figure 3).
Figure 3. Brent crude oil prices and Dutch TTF gas prices
Sovereign bond yields soared to fresh multi-year highs in early October. Longer-dated US Treasury yields have surged to highs last seen in 2007 in a global bond market rout. This comes after neutral real rate expectations and term premium have adjusted higher (see Figures 4, 5), policy expectations raised amid still strong economic data, and heavy Treasury bond supply. We expect bond market volatility to remain elevated in the near-term, given a potential US government shutdown next month and scheduled ratings agency updates.
Figure 5. Contribution to 3-month change in US 10y yield
Latest moves suggest yields can still go higher, presenting upside risks to our global 10-year yield forecasts. In our view rising/higher-for-longer rates in the US could have broader effects such as pressuring the BoJ to exit yield-curve-control earlier in 2024, adding upside risks to our Japanese yield forecasts. Still, we expect yields to fall from here as our baseline of slower growth and lower inflation takes hold.
Figure 6. Evolution of Fed funds rate futures
Baseline view
Downside risk and uncertainty have risen following the outbreak of war in Israel. We see a higher likelihood of the BoE keeping UK rates unchanged at 5.25% after its September meeting.