Central Banks Missed Their Opportunity To Calm Markets: Goldman Macro Traders Warn 'Energy Is Driving Everything'

Authored by Goldman Sachs macro traders, Cosimo Codacci-Pisanelli and Rikin Shah,

REACTION FUNCTIONS

ENERGY IS DRIVING EVERYTHING... 

To state the obvious, macro markets are being driven by the price of energy.

The first part of the week saw correlations between energy and rates recede, but that reverted quickly in the second half of the week.

A reminder that when vol picks up, that beta will remain high, with the revealed central bank reaction functions this week only enhancing that view. Iran’s attack on Qatar’s Ras Laffan LNG facility, which is responsible for 20% of the world’s LNG supply revealed two things.

• First, the escalatory path that Iran will take and the very clear leverage that they will exercise on the global economy via higher energy prices.

• Secondly, the attack showed the potential long term damage of the conflict on supply. Reports suggest that the attacks will lead to a 17% outage of supply from the facility for the next 3-5y, which works out at 4-5% of global LNG supply.

It is hard to see a quick reopening of Ras Laffan at this stage and the longer the outage, the more risk that European storage levels are low going into winter next year. Daan Struyven touches on the risks from longer term oil supply disruption and the possible offsets from higher OPEC supply or demand destruction, illustrating that in both the short and long term, that risks to prices are to the upside.

The longer the conflict goes on, the more the distribution opens up on the topside to energy prices, and the longer it may take to normalise on a resolution. 

The path to a quick reopening of the Straits feels very narrow right now; the convex move for the energy complex is still higher from here.

Crude and TTF continued to scream higher this week...

GROWTH? ALL ABOUT FISCAL… 

Since the initial Iran strikes, inflation risk has been the dominant rates market driver. As expected, front end yields have led the move and yield curves have bear flattened. In fact, rates markets have generally outperformed their typical beta to energy at the front-end of inflation curves.. most meaningfully in the UK. Looking forward, especially after what we learnt this week around the central bank reaction functions, further moves higher in oil and gas will continue to be the dominant driver of front end rates.

 
When we look at belly rates (that have been dragged higher with the front end moves) the big question is where does growth shake out from this? Is this a supply side shock that is demand destructive and increases recession risks if central banks do engage in mid-year hikes. Or are we met with fiscal support again which helps to keep demand afloat. As hike pricing re-accelerating in Europe and UK, curves have started to flatten aggressively (for example, Z6/Z8 UK flattened over 60bp this week). The market is starting to price a forward growth slowdown. However, this all depends on if there is a fiscal response.

SFIZ6/Z8 flattened sharply this week, reflecting some of the negative growth implications of the energy shock...

Diving further into the UK fiscal situation, the Spring Update earlier this month showed £23.6bn of breathing space by 2029/30 vs the government's self-imposed current deficit constraint.

Back of the envelope, we would guess the fiscal headroom would be reduced by ~£12bn from rates & inflation market levels alone. This only leaves small space for fiscal support (unless the fiscal rules are broken of course); for context, in 2022/23, the government spent ~£60bn on energy price support. 

Front end yields are going to continue to track oil and gas moves.. especially with the central bank forward guidance this week. Belly & longer end rates will largely be impacted by the growth outlook.. and curves have started to flatten.

The key component of this is whether we see a fiscal response or not. UK, as one example, has very little fiscal room after the rates moves.. so fiscal rules will need to be broken if we were to see material support.

More broadly, FCI continues to tighten across the board.. most aggressively in the UK, followed by the US. 

US 2026 PRICING JOINS THE REST… 

A week ago, most DM countries were pricing hikes by end 2026 with US pricing still firmly in cut territory. After a global rate sell-off this week and a hawkish Fed meeting, we close the week with all US cut pricing for this year having unwound.

At this week’s meeting, only one participant dissented in favour of a cut (GIR expected three). Powell noted that the unemployment rate has been roughly stable and said that while Fed officials think there has been zero net job creation in the private sector recently, that is likely the breakeven rate. Additionally, Powell put the risks to employment and inflation on an equal footing, took seriously the risk from the oil price shock to inflation expectations against a backdrop where inflation has been high for five years, and said that “mildly restrictive” policy is appropriate for now. 

With all front end pricing trading with a beta to commodities, we are neutral on US front end rates at these levels for now.

However, we still believe the bar to hike will be higher than elsewhere in the US under Warsh. Whilst financial conditions have been tightening, it remains surprising to us how well US equities have held in during this crisis. A more material move lower could be the trigger for the market to push the growth shock trade. In that scenario, the Fed will likely be the first CB to react.. less exposed to energy and a dual mandate. Could that bring back the insurance value in being long front end US duration?

ECB LEAVE OPTIONS OPEN... 

Lagarde delivered a composed and balanced performance at the meeting, but left all options on the table and the staff scenario analysis suggests a clear path to hikes on further energy moves. The economic assessment was balanced (higher inflation vs downside growth risks), while the most notable aspect of the forecasts was that they showed a higher pass through to core from the energy shock (illustrating risks of second round effects). There was a clear attempt to maintain optionality on the policy path, and Lagarde suggested a number of metrics that would factor into the decision – commodity prices, supply chains, inflation expectations, wage trackers and PMIs.

The two alternative scenarios in the forecasts (adverse and very adverse) were interesting and helpful in trying to pick out a policy reaction function.

GIR backed out the policy impacts of each of the three sets of forecasts as implying a 25bp hike in the baseline, 50-75bps of hikes in the adverse and 100-150bps hike in the very adverse scenario.

Energy is already higher of course than their baseline forecast, but we back out the adverse scenario as implying Q2 averages of $119 for oil and €87 for gas – so still somewhat higher than where the market currently is. Where does that all leave fair value for the front end in Europe? It’s hard to say with any degree of confidence, based on their scenario analysis 50bps of hikes feels reasonable to us, which the market is now well through. 

The hawks made clear following the meeting that they will push for quick action if there is no quick solution in the Middle East, the beta of the front end will remain high to energy as a result. 

THE BOE BAFFLES... 

The Bank were hawkish and revealed a reaction function that showed they will not hesitate to respond to the energy shock by tightening policy.

They highlighted upside risks to inflation and the heightened risks of second round effects given recent inflation spikes. They dropped their easing bias from the policy language and replaced it with they “stand ready to act” to ensure inflation meets their target. They explicitly stated the possibility of tightening policy on a “large or more protracted shock”, with even Dhingra (previously a dissenting dove) showing openness to a hike in such a scenario. Finally, on timing, there were a number of implicit suggestions that April could be live for such a move. There was some acknowledgement of the negative growth impacts in the minutes, and Bailey made an attempt to temper the sell-off in an interview following the meeting, but it did little to offset what is a clear revelation of a much more hawkish reaction function to the energy moves than we had expected. The Bank were patient to normalise policy last year given ongoing concerns around upside inflation risks, and policy rates are still restrictive as a result. If anything, this could have been a point for the Bank to claim victory on their cautious approach.

SFIZ6 has sold off 144bps in three weeks...

With a labour market that is still clearly softening and an already restrictive policy stance it’s hard to rationalise the Bank’s response. Clearly the scars of 2022 are there.

We close the week with 88bps of hikes priced for the year. That seems high in the context of the limited fiscal room to respond to the growth shock, but we have to accept a degree of humility given the price action. 

The Bank have shown their finger is on the trigger to hike if energy pressures remain...similar to Europe, the beta to oil and gas will remain high as a result.

IN SUMMARY...

Energy remains the driver of all macro assets, and the pathway to a quick resolution and reopening of the Straits feels narrow right now as Iran exercises the point of maximum global leverage. The impacts of the conflict on energy supply are becoming more lasting in impact the longer it goes on, and that leaves convexity still to the upside for energy. Central banks had the opportunity to calm markets, but the scars of 2022 are clear, and the Fed, ECB and BoE all failed to control the front end rate sell off.

For the ECB and BoE, higher energy will lead to rate hikes quicker than we had expected, which means the beta of front ends to oil will remain high. The extent of the market-implied policy tightening in the face of a severe supply-side shock suggests significant downside growth risks to come, which should continue to flatten the forward curve, absent a large fiscal response (is there space for one this time round?).

Equities at an index level continue to hold in relatively well in the context of rate and commodity moves...a more material drawdown and sharp FCI tightening might be the trigger for the market to focus on growth impacts more closely.

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