Strategists at Bank of America said even if the war in Iran settles or reaches an end, there is no certainty that output will resume to its previous level.
If oil prices keep climbing in the near term, interest rates could move "significantly higher," according to Bank of America - even if the Iran war is resolved.
Ralph Axel and Oliver Levingston, strategists at the investment bank, found that rates and oil have been dramatically correlated in the past few decades in the U.S., U.K. and Germany.
"If oil prices continue to rise over the next 3-6 months, we could see significantly higher interest rates," they said.
The yield on the U.S. 2-year Treasury BX:TMUBMUSD02Y is up 111 basis points since the start of the year, but on days when oil prices have risen, it increased by about 196 basis points. On other days, it fell by 83 basis points. In the U.K. and Germany, it has generally been starker.
"If oil prices rise, we think rates will too, especially at the front end where long-end term premium is less of a factor and monetary policy expectations play a larger role," they wrote in a Thursday note.
The strategists said the sequence of events usually looks like spiking energy prices (BRN00) (CL.1) leading to higher yields on bonds as investors demand greater compensation, which results in central bank governors entering meetings with increased projections of hikes - eventually deciding to deliver on those expectations.
The Federal Reserve would likely face fewer challenges than other central banks if it enters a cycle of tightening monetary policy because of robust consumer spending, stronger-than-expected gross domestic product growth and a resilient labor market in the U.S.
Despite oil futures now significantly lower than before Tuesday's midterm elections as markets increasingly price in the war in Iran ending sooner rather than later, additional rises in oil prices cannot be ruled out, especially if the conflicts in the Middle East or Ukraine intensify.
"While the evolution of geopolitical conflict is impossible to predict - the course of the Ukraine-Russia war serves as an example of how surprisingly long such conflicts can last," Axel and Levingston wrote. "Even if the Iran conflict ended soon or settled down greatly, we cannot be assured that crude supply from the Gulf would reliably resume to its pre-war rate or that Ukraine would cease to hit Russian refineries."
Based on the analysis of the key relationship between rates and oil, the strategists advised a pay-fixed position in U.S. two-year rates as they don't see the Fed pushing against market expectations of hikes heading into meetings.
"With a new Fed Chair who has yet to establish strong credibility in the inflation fight, we think holding rates in meetings with over 50% chance of a hike priced could wind up losing control of long-end rates," they said.
-Nora Redmond
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