ROI-Why oil-spooked markets may be wrong about the Fed: Joachim Klement

By Joachim Klement

LONDON, March 18 (Reuters) - Markets on edge about the Iran-war-driven oil shock are extrapolating today's stress far into the future - and may thus be badly misjudging how dovish the Federal Reserve will be this year.

The oil price spike, which sent Brent crude into triple digits last week, has increased U.S. inflation risks and reduced market expectations for Fed policy easing just as the Federal Open Market Committee was getting set to meet on March 17-18.

Going into 2026, money markets priced two to three interest rate cuts for the year, but now they expect only one.

If oil prices remain near current levels – with both Brent LCOc1 and West Texas Intermediate crude futures CLc1 hovering around $100 a barrel – or rise further amid a prolonged conflict, markets are probably right. There would be little room for the Fed to cut in these scenarios, and it may even be forced to hike, as some members of the FOMC are already indicating.

In November, I wrote about why the Fed would likely reduce rates more than markets expected in the coming year. While I admit the macro backdrop has shifted significantly since then, there are four key reasons why the Fed could still surprise on the dovish side.

FOUR ARGUMENTS FOR CUTS

First, as I argued in November, the Fed has been under political pressure to slash interest rates and has historically accommodated forceful administrations with policy easing.

This pressure is likely only going to intensify once the new Fed chair arrives in May to replace Jerome Powell.

President Donald Trump's nominee for the job, Kevin Warsh, who still needs to be confirmed, is likely to push the FOMC in a more dovish direction. He has expressed optimism about the disinflationary effects of artificial intelligence, and is being appointed by a president who has repeatedly called for rate cuts.

Second, there is the accelerating weakness in the labour market. The U.S. economy lost 92,000 jobs in February and has seen essentially no job creation over the last six months compared with an average of 27,000 new jobs per month in the preceding half year.

This gives the Fed a good reason to cut interest rates even if inflation pressures remain moderate - though not if there is a significant spike in price increases.

Third, stress is building in private debt as investors pull money from funds, raising the risk of a liquidity crunch.

The Fed is not a macroprudential central bank that cuts rates pre-emptively to protect credit markets. But if there is significant stress, let alone a crisis, rate cuts are its most effective tool. Most private loans are floating-rate, so lower policy rates would feed through quickly, directly easing any stress.

Fourth, and most important, today's elevated oil prices may not last.

Plans for the largest-ever release of strategic petroleum reserves – 400 million barrels - have thus far had no impact on prices. In fact, crude has gone up since the announcement.

Realistically, the only thing that can decisively lower prices is a reopening of the Strait of Hormuz, through which roughly 20% of the world’s oil and gas previously transited.

Given that this is an election year in the U.S., the clock for ending the conflict, reopening the strait and bringing down oil prices is already ticking.

The U.S. may be a net oil exporter, but prices for crude and gasoline are based on global supply and demand, as evidenced by the rise in average U.S. gas pump prices to above $3.70 per gallon last week.

Trump won the 2024 election in large part because of his promise to bring down prices after the inflation spike under his predecessor Joe Biden. His Republican Party, which is clinging to a fragile majority in Congress, will not want to face voters in November’s midterm congressional contest amid rapidly rising fuel costs.

Democrats are already trying to turn higher prices into a political weapon, and while Trump has brushed this off so far, that will be harder if gasoline prices remain elevated into the summer.

Of course, any action by Trump now may be too late. Energy infrastructure in the Middle East has been damaged, supply chains have been upended and the supply glut holding down prices for much of last year has disappeared.

Still, even if oil prices do not quickly return to their pre-war levels, they are still apt to fall meaningfully once it's clear that the Strait of Hormuz will be reopened.

Markets currently see a Fed cornered by the prospect of rising inflation, which is reasonable but short-sighted. Many of the factors that supported rate cut expectations before the war have not changed.

The question now is how quickly Trump will “declare victory” and get oil flowing once again.

(The views expressed here are those of Joachim Klement, an investment strategist for Panmure Liberum.)

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