CSC has released a research report stating that due to surging oil prices, market expectations for the Fed's first rate cut have been pushed back to December, while pricing for the ECB suggests two rate hikes this year. However, the firm believes that the US-Iran conflict will not reverse the Fed's rate-cutting cycle. While the timing of rate cuts in the second half of the year may be delayed, the overall direction of easing remains unchanged. The total magnitude of rate reductions for the year is not expected to shrink, and there is potential for compensatory rate cuts, similar to 2024 when no cut occurred in July but a 50 basis point cut was implemented in September. CSC maintains its forecast for 3-4 rate cuts this year and remains bullish on US Treasuries.
The firm indicates that a prolonged conflict is not its base case assumption, with a high probability of de-escalation within one to two months. A simple rise in oil prices and commodity costs is unlikely to drive up US core CPI. Given that employment and consumption are already weak, high oil prices introduce additional negative feedback, potentially further suppressing growth. This year's policy trajectory may resemble the pattern following the one-time tariff shock anticipated in 2025. CSC's main views are as follows:
Following the oil price surge, expectations for the Fed's first rate cut this year have been delayed until December, while expectations for the ECB even include two rate hikes this year. Pricing from CME futures markets indicates that the Fed's first cut will only occur in December, with a second cut not expected until December of the following year. Before the US-Iran conflict, the market had priced in 2-3 rate cuts for this year. Meanwhile, the situation for the ECB is more severe; the policy rate priced into swap markets for year-end is 40-60 basis points higher than at the start of the year, implying a probability of at least two rate hikes. Market expectations for rate cuts have significantly diminished, with concerns even emerging about the risk of tightening rate hikes.
Nevertheless, the firm maintains that disruptions from the US-Iran conflict and oil prices are unlikely to derail the Fed's rate-cutting cycle. The timing of cuts in the second half may be delayed, but the direction of easing will not change. The total scale of rate cuts for the year will not be reduced, and compensatory cuts cannot be ruled out, analogous to 2024 when no cut occurred in July-August but a single 50 basis point cut was implemented in September.
(1) A prolonged conflict is not the base case; probability of de-escalation within 1-2 months remains high. Despite increasing market concerns about tail risks, the US-Iran conflict differs significantly from the Russia-Ukraine conflict, with a much lower risk of prolonged duration. First, Ukraine receives substantial military aid from the US and Europe, which Iran lacks. Second, during the Russia-Ukraine conflict, global oil supply saw no substantial cut, only a change in flow patterns, whereas the current disruption from the Strait of Hormuz blockade has a greater impact, negatively affecting all countries overall. This negative feedback creates an incentive for nations to seek a swift end to the conflict. Third, the US is directly involved, and President Trump faces multiple constraints. If the conflict de-escalates before mid-year, oil prices could see a significant retreat. Based on implied probabilities from betting data, the probability of a ceasefire in May-June remains around 50-60%.
(2) A simple rise in oil prices, or even broader commodities, is unlikely to catalyze an increase in US core CPI. Conversely, against a backdrop of weakening demand and employment, core CPI may even tend to decline. Rising oil prices directly push up US Headline CPI, which is uncontroversial given the significant weight of energy-related items in the CPI basket. However, this is often short-term; once oil prices stabilize or fall, the month-on-month figure turns negative, and the year-on-year figure recovers after base effects diminish. The impact of oil prices on core CPI, however, is relatively low. On one hand, its weight is not particularly large. On the other hand, historical data shows that the magnitude of oil and metal price increases seen since the beginning of this year has occurred numerous times in the past, often lasting 1-2 years. During such periods, US core CPI mostly did not exhibit synchronous or lagged upward trends and often tended to decline. The period 2020-2022 was an exception, but the upward trend in core CPI was already established before the Russia-Ukraine conflict and was not caused by the subsequent oil price rise. Therefore, historical data lacks evidence that rising oil and commodity prices drive US core CPI higher. The underlying logic may be that rising oil prices significantly suppress consumption and demand, leading to lower consumption and prices for non-energy items. In extreme scenarios, persistently high oil prices could lead to a recession, further weakening the foundation for inflation. For judging inflation trends, core CPI is more critical.
(3) Employment and the economy are already weak; high oil prices introduce additional negative feedback, potentially worsening conditions. Current data for GDP, employment, and retail sales are generally mediocre. High oil prices could further suppress the economy. On one hand, they reduce households' real disposable income, decreasing consumption of other goods. On the other hand, if the Fed genuinely delays rate cuts due to short-term inflation disturbances, high interest rates would exert additional pressure on the economy.
(4) Fed Rate Cut Outlook: Limited upside inflation risk, increasing downside employment pressure, rate cuts in H2 still anticipated. As the preceding analysis shows, under the base scenario, oil price disruptions are unlikely to cause sustained month-on-month increases in overall US CPI or a reversal to rising core CPI. Inflation risks appear overestimated at present. Simultaneously, the conflict has a definitively negative impact on US employment and growth. If subsequent employment data weakens further, the Fed's focus will likely remain on employment. This year's policy path may resemble the pattern following the anticipated 2025 tariff shock. The goods component of CPI saw a significant but brief rise after the tariffs, quickly receding without altering the overall trend. Rate cut expectations were heavily suppressed around mid-year but recovered shortly thereafter. The Fed's subsequent stance may mirror last year's approach, maintaining that the oil price impact is a one-off event. While the specific timing of cuts might be slightly delayed as a result, the overall direction of easing remains unchanged, potentially even leading to compensatory cuts later. The firm maintains its forecast for 3-4 rate cuts this year, remains bullish on US Treasuries, and views the recent yield increase as a buying opportunity.
Risk warnings include US inflation exceeding expectations, US economic growth exceeding expectations, a US recession exceeding expectations, a European energy crisis exceeding expectations, and intensifying global geopolitical risks.
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