After One Of The Largest Deleveraging Events Ever; Goldman Sees Week Ahead As 'Crucial' For Rates Market

Energy prices are the dictator of all macro asset prices right now, but as Goldman macro traders Rikin Shah and Cosimo Codacci-Pisanelli, the big questions remain: which assets have now overshot the oil move and how have cross-asset class correlations changed (and will they remain) after one of the largest rates market deleveraging events in recent history.

ENERGY ASYMMETRY IS STILL TO THE UPSIDE... 

A quick reminder of where GIR are now on oil – they assume a baseline of a 21 day near closure of the Strait of Hormuz before a 30 day gradual recovery, leaving a Q4 forecast of $71/67 for Brent/WTI. The situation remains volatile and the longer the disruption of the largest oil shock on record, the further the distribution opens up to the top side for oil and gas. The skew of risks remains to the upside should the closure of the straits last longer, and we think that a closure through March can see oil prices break through the 2008 peak. In a 60 day disruption scenario GIR forecast Q4 oil at $98/89.

Should the US withdraw military action then prices would of course fall, but it is still unclear what the Iranian response would be to this, and whether they will continue to leverage control of the straits to some capacity. The convex move from here is still to higher prices. 

WHERE HAVE WE LANDED… 

When we ask ourselves, why has XYZ asset moved over the past two weeks, the answer to almost everything is “Iran / oil”.

 *Please note: Standard Deviation is calculated on an out of sample of 9b changes over the last 5 years. 

Whether it is front end rates, rate curves, USD FX or equities, the correlation to oil has been very high over this period.

Positioning clearly exacerbating some of the moves.

Firstly, the AI disinflation theme was front and centre over the previous few weeks, along with de-dollarisation, which did not help the market setup into the Iran escalation.

Secondly, position sizes were decided on the back of the previous realised volatility. Before this shock, the 10 day realised volatility of EUR 1y1y rates was consistently between 30-40bp/year; the recent 2 weeks moves has realised volatility 5x this. Thirdly, the market hedges failed to deliver (e.g. Gold). The focus had been on labour market risks and risk-off hedges were centred around lower rates. The bear flattening quadrant on an inflation impulse was not owned. 

 

The big questions we ask ourselves are:

1) which asset moves have now overshot relative to the oil move, and

2) how have correlations shifted amongst asset classes.

IMPLIED correlation moves since the start of the Iran escalation.  

 Top table = current implied correlations. Bottom table = the changes since the start of the escalation. 
 ++ and -- = >10 point in correlation. + and - = 5 point move.

One thing is clear if fading moves... energy hedges are needed. 

US RATES IN THE BACKGROUND… 

After US rates played a backseat initially in the first leg of the recent front end sell-off, the moves started to spillover this week.

Looking at current Fed pricing, we have a few observations.

Firstly, absent a few past scenarios (that didn’t last long), it is rare for the Fed and ECB cycles to de-correlate. Current pricing of hikes in Europe (and other DMs) and cuts in the US are hard to both realise.

Secondly, a higher inflation path will make it harder for the Fed to start cutting soon.

However, the Fed do have a dual mandate, labour market downside risks remain (and will continue to remain over time as AI adoption increases), and Warsh will likely be skewed dovishly.

As a result, we still believe the Fed’s next move is likely to be a cut rather than a hike, but the bar for an imminent cut has raised slightly. 

Put together, we find it hard to see the ECB hike and the Fed cut rates at the same time.

If either CB deviate from current levels, the other is more likely to stay on hold. The next few weeks price action will be dictated by energy prices, but once we have more clarity we look for late 2026 FOMC gaps to flatten. 

EUROPEAN FRONT END BACK TO LIFE… 

After 9 months of the ECB on hold and the market debating around which side of the distribution was more likely, front end rates have now broken out the range; we end the week with ~50bp of hikes priced for 2026. Taking a step back from the volatile daily price action, GIR update their European forecasts under our new energy forecasts. Under our baseline scenario, we see headline inflation peaking at 2.9% in Q2 (vs 2% before the war) and a limited pass through to core inflation (only 0.1pp). It is largely the very adverse scenario (60 day disruption of the Strait of Hormuz) where the inflation profile becomes more unhinged.. with headline reaching 4.4% by Q4 and a further 0.8pp boost to core inflation. However, in the latter scenario, we estimate the total growth hit to 0.9%.

The big unknown is the ECB reaction function and the variables around that. We will learn more at next week’s ECB meeting, but Schnabel and Lagarde have recently taken a more balanced view, highlighting some differences relative to the 2022 energy crisis. In volatile political environments (where the end outcomes are unknown), the CB stance is often one of patience. Midweek we temporarily got to priced 1 ECB hike by June this year (currently 19bp); any guidance next week from the ECB that highlights patience will help some of this hike pricing unwind.

The starting point of rates is higher than in 2022, the current fiscal stance is less expansionary and the current shock looks more global in nature given the large oil price increase. However, the ECB ultimately do have a single mandate.

The big variables to state the obvious are 1) what the ECB reaction function is if oil prices shoot up to extreme levels (say $150/bbl), and 2) what the fiscal response is.

A large oil price move to $150/bbl without a fiscal response will be a large growth shock.. it would be a European curve flattener as the market will need to price an inversion in latter years. Perhaps a more moderate but persistent oil price increase that feeds more structurally into inflation is what can cause a slightly more delayed, extended and sustainable ECB hiking cycle.. but that can take time.

The fiscal response will be the key decider around the ECB reaction function. Our base case remains that the ECB stay on hold, but the distribution very clearly is towards hikes, and the market will need to price risk premium to that direction. 

If the SOH disruption is sustained, the fiscal response will be key in determining the demand side of the equation, and hence the ECB distribution.

Terminally we think the front end has overshot, but for now front end rates are likely to just track the oil price moves.

In the longer term, the correlation of European belly rates to oil prices will be a function of the fiscal response. 
  
FRONT END UK THE BETTER LONG?... 

The sell off in the front end of the UK has been an even larger move than Europe – 2y UK rates are ~60bps higher since the start of the conflict, vs ~40bps higher in Europe, or in standard deviation terms – a 10 stdev move vs 8 in Europe. The UK now prices 25bps of hikes to the end of the year. We think the bar to hikes for the BOE is much higher than in Europe. Firstly policy rates are still in restrictive territory and secondly there is much more slack in the UK economy with labour market momentum still weak. The volatility will be a reason for the Bank to pause and exercise patience... and Pill will no doubt be pounding the hawkish drum, which will make cuts harder for as long as the energy prices remain elevated... but it’s a narrower path to get a scenario where the BoE could be hiking.

Against our baseline oil scenario, GIR still forecast the Bank cutting in July, November and February of next year to a terminal of 3%. In the event of a conflict resolution it feels that the UK has more room to correct than in Europe and remember that the UK labour market is more exposed to AI job displacement risks. In this context we think that the front end of the UK is the better long than Europe (but again the near term path will be a function of positioning and oil prices).

On a short term basis April MPC is only pricing just north of 1bp cuts... it’s extremely hard to see how the Bank could hike this soon even in a severe adverse scenario so this feels relatively asymmetric to playing for a quicker resolution to the conflict. 

IN SUMMARY...

The rates market has gone through one of the largest deleveraging events in recent history.

The extent of the sell off in European and UK front ends is starting to show some terminal value in our view, but everything for now will continue to be driven by the oil price.

For every day and week longer of disruption the distribution for energy opens up further; the convex move is still to higher prices.

For Europe we are focused now on the fiscal response to higher energy prices and how this feeds through to the ECB reaction function.

The path to hikes is harder to plot in the UK and that makes it a better long in our view.

Next week will be crucial as we will get the first look at how CBs will responds to the energy crisis and whether they are reading from the 2022 playbook, or whether this time is different. 

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