What's Driving the Markets?
President Trump's approval ratings are hovering near historic lows. This appears to have prompted a more confrontational stance on several geopolitical issues. Trump has declared the ceasefire agreement with Iran void. At the same time, tensions within NATO are becoming increasingly visible. Trump has expressed strong dissatisfaction with Europe's failure to support the United States during the conflict in the Middle East and with Spain's unwillingness to increase defence spending. In addition, the potential annexation of Greenland by the United States has once again returned to the political agenda.
With respect to developments in the Middle East, our base case is that Iran has relatively little to lose and much to gain from escalating tensions:
- Ahead of the U.S. midterm elections in November, it is highly unlikely that the United States will initiate a full-scale military conflict with Iran. Such a move would be deeply unpopular with American voters.
- Rising geopolitical tensions are likely to push oil prices higher. This not only generates additional revenue for Iran but could also further erode Trump's popularity ahead of the elections. Iran is likely hoping this will strengthen its negotiating position in upcoming talks on its nuclear programme and control over the Strait of Hormuz.
If this assessment proves correct, disruptions to shipping through the Strait of Hormuz are likely to persist for an extended period. While this does not necessarily imply oil prices will surge to USD 150–200 per barrel, it also suggests prices are unlikely to remain sustainably below USD 70. We therefore expect Brent crude to trade within a range of approximately USD 70–100 per barrel over the coming months.
What Would This Mean for the U.S. and European Economies?
For Europe, sustained higher oil prices would translate into significantly higher energy import costs while also putting upward pressure on inflation. The extent of this inflationary impact will largely depend on the magnitude of second-round effects—that is, the extent to which higher energy costs feed through into the prices of energy-intensive goods and services.
At the same time, elevated energy prices are likely to weigh on economic growth, which should initially limit these second-round inflation effects. However, the longer energy prices remain elevated, the greater the likelihood that broader inflationary pressures will emerge.
In practical terms, if oil prices remain close to USD 70 per barrel, we expect the ECB to raise interest rates by one additional 25 basis points. Should oil prices move closer to USD 100, as many as three additional 25 basis point rate hikes would become a realistic possibility.
In the United States, economic growth is expected to remain more resilient than in Europe, provided equity markets do not experience a significant correction. As a result, second-round inflation effects from higher oil prices are likely to materialise more quickly. However, U.S. interest rates are already considerably higher than in Europe.
Overall, we expect that if oil prices remain around USD 70 per barrel, the Federal Reserve will deliver one further 25 basis point rate hike. If oil prices approach USD 100, we believe as many as three additional 25 basis point rate increases could still be implemented this year.
