Too Much Inflation, Too Little Growth: Goldman Strategists Warn Rates Are Fighting The Last War

Even as Iran war headlines oscillate, macro markets still need to price an energy price shock of uncertain duration.

While the initial impacts - higher inflation and a hawkish shift in policy rates across G10 and EM economies - are a rational repricing, top Goldman Sachs strategists, Dominic Wilson and Kamakshya Trivedi, warn that the challenge is how far that repricing needs to go to reflect the upside tail of the distribution.

Too much inflation, too little growth

A perfect storm involving potentially the largest energy supply shock since the 1970s, concentrated received positioning in a market priced for cuts, and the scars of underestimating the 2022 inflation shock means that central bank pricing has overshot most modal upside estimates of what is warranted.

Exhibit 1: A sharp hawkish repricing in markets, but limited growth downside so far

This is where the clearest asymmetries have emerged.

Across FX, credit, and equity markets, the headline moves have been smaller, though markets have been reasonably differentiated in pricing the relative terms-of-trade impacts between energy exporters and importers.

The big question in those assets is whether we see a deeper and broader drawdown because the energy disruption from the Strait of Hormuz is longer-lasting and the market moves to worrying about severe growth downside.

That would put more outright pressure on equities and EM, may provide some relief to the rates complex, and boost the Dollar further as it cuts against the prevailing trend of more globally diversified allocations (non-US versus US).

However, if a swifter de-escalation can be achieved, in line with recent optimism, some of those prior themes of global equity outperformance and Dollar weakness should resume and may even be reinforced by recent events.

A hawkish shift—both in markets and central banks. 

The hawkish repricing at the front end of curves stands out amid all the shifts in markets since the energy price spike began. The UK (in G10) and Hungary (in EM) are the prime examples of this: at the peak, market pricing to end-2026 swung from pricing 54bp of cuts to 102bp of hikes in the UK and from 77bp of cuts to 118bp of hikes in Hungary. Equally notable, before Monday's (23 March) de-escalatory headline, the market was pricing in 92bp of hikes for the ECB, 23bp of hikes for the Fed, 128bp of hikes in South Korea, and 70bp of hikes in Mexico.

Apart from the energy price moves themselves, the aggressive rate moves have also been fuelled by surprisingly hawkish central bank rhetoric: Fed Chair Powell's guidance that mildly restrictive policy remains appropriate; zero votes for rate cuts from the Bank of England; and comments from ECB governors that have sounded open to a hike at the next meeting in April.

Exhibit 2: Market pricing has shifted from cuts to hikes in almost all G10 and EM markets

Policy rate hikes/cuts priced to end-2026 before the start of the war (February 27), currently, and versus GS forecasts

Source: Bloomberg, Goldman Sachs Global Investment Research

Part of this hawkish reaction appears to stem from the fact that overall financial conditions have not tightened dramatically, owing to the relative resilience of equity and credit markets thus far.

That tightening may be necessary for hawkish concerns about second-round effects on inflation to recede, though energy price increases may already be doing some 'tightening' in less obvious ways.

Front-end rewards worth the risks in many scenarios. 

Market pricing of many front ends now looks quite asymmetric across several scenarios—we think the hike risk priced in the US, and multiple hikes priced in Europe will prove too hawkish.

From a fundamental standpoint, this repricing may be reflecting some scar tissue from the inflationary episode of 2022. And G10 central bankers' focus on indirect and second-round effects and the risk of un-anchoring inflation expectations have clear echoes of that period. But there are also important differences: there is a less expansionary fiscal impulse to start with; any fiscal support that emerges is likely to be more targeted; broad-based COVID-related supply chain disruptions are less of an issue so far; and labour markets are softer than post-pandemic.

Exhibit 3: A different starting point for fiscal support coming into 2026 compared with 2022

Primary balance as a percent of GDP

Source: IMF, Goldman Sachs Global Investment Research

So there is a risk that policymakers are fighting the last war. An interesting 'tell' may be that EM central bankers, who are generally quicker off the mark in responding to headline inflation shocks, are sounding more balanced for now (including in Brazil, Czechia and Hungary). Although weaker growth signals ultimately stabilize front-end rates, liquidity and positioning remain a risk with more constrained risk appetites in this space.

The experience of the 1990s also suggests that even in an episode where the rate increases eventually reversed, it is hard to rally a lot until energy prices convincingly drop back even though the peak in yields can occur before the peak in oil. But this is one area where we clearly see value now.

Still a wide range of paths possible. 

The near-term outlook will remain dominated by developments in the Iran war. There are still a wide range of outcomes. On a benign path, we could see meaningful progress towards de-escalation. Even without clear resolution, we think any path that allows the market to reduce the weight sharply on the deeper downside tails is probably sufficient for recovery.

As we saw earlier this week, we would expect quick relief in areas that have seen most pressure: European and cyclical assets, non-USD currencies and front-end rates, alongside sharp declines in volatility and skew; and underperformers such as Korean equities and HUF.

At the other end of the spectrum, a major escalation and further oil price spike could prompt clearer recession worry.

This would hit risky assets and volatility harder but could ultimately challenge a broader range of assets that have been more resilient until recently (e.g., copper, BRL, AUD).

Along this path, we think we would likely see a turning point towards lower yields and a broader shift lower in X-JPY currency pairs.

Exhibit 4: Relief phases have seen outperformance in assets that saw most pressure

Source: Goldman Sachs FICC and Equities, Goldman Sachs Global Investment Research

In between these scenarios, a protracted disruption, but one where the deep tails are not activated, might see some US equity recovery, partial relief in non-US assets and some reversal in hawkish policy pricing.

But terms of trade differentiation across FX and equities could come more sharply into focus. We would expect some risk relaxation, but one more focused on the potential beneficiaries of structurally higher energy prices than at the start of the year.

Tails wag the dog. 

The pricing of this kind of wide distribution is always challenging.

As we have seen, small shifts in perceptions of deep tail risks can drive markets sharply in either direction.

Exhibit 5: Growth pricing still below our baseline US growth forecasts, but still room for deeper downside in adverse war/energy price scenarios

Source: Goldman Sachs Global Investment Research

Most of our tools suggest that our baseline growth forecasts have already been priced, but that the market would still have plenty of room to move in many places if the more adverse scenarios from our commodity team were to play out.

This makes it harder to find good asymmetric asset outcomes that do not depend on some edge in understanding how the conflict may evolve. In that respect, front-end pricing looks more extreme than equities, both in terms of the absolute moves and the comparison to our own forecasts. Outside rates, we think markets have been slower to price the kind of downside tail that many political and commodity experts think is still a meaningful risk. Equity volatility has been rising, and markets are much less complacent than they were.

But short-dated SPX put volatility is still well below the levels we saw not just in April 2025 but also in the growth scare in August 2024.

The 'Liberation Day' experience, where policies were quickly reversed, has made investors more reluctant to press downside views or hedges, even though the resolution path here looks more complicated.

Relative to those prior episodes and the convexity in some of the oil and growth outcomes, the deep downside tails to equities and credit still look underpriced.

Pre-war worries remain in the shadows. 

The focus on the war has pushed the market’s prior concerns (especially the overlapping worries about AI disruption, overvaluation and turbulence in private credit) mostly into the background for now.

But beyond any initial relief, these issues could easily resurface. Growth was already set to slow into H2 as the US H1 fiscal boost fades.

Exhibit 6: Iran war shock comes on top of already softening labour market

Source: Goldman Sachs Global Investment Research, Jaimovich and Siu (2020)

Tighter financial conditions and the income hit from oil prices threaten to add to those pressures. 

Our baseline view is now for the US unemployment rate to drift more clearly higher this year and so worries about a labor market tipping point may also be more persistent. Uncertainty around the impact of the US mid-term elections might also come more squarely into focus.

These dynamics may cap the potential upside in any recovery, unless rates fall more sharply. They also reinforce our view that credit spreads may be under (modest) widening pressure even in our relatively benign base case and that there are good reasons for longer-dated equity volatility to continue to drift higher over time.

USD–Not the end of the (down)trend. 

The past month has been a good reminder of the Dollar’s safe-haven attributes in an oil shock, with most of Europe and Asia on the wrong end of the terms-of-trade shock. The USD rebound is understandable; but with the Dollar now roughly flat year-to-date, the key question is whether this shift is persistent or not.

On the one hand, most of the factors that weighed on the Dollar earlier this year—less exceptional return prospects and a fragile labor market—have not changed.

On the other hand, a more lasting disruption would reverse many of the themes that were expected to dominate FX markets this year. The market has already switched to trading energy terms-of-trade losers and beneficiaries, rather than differentiating along a procyclical axis, and that type of differentiation can persist while geopolitical tensions (and energy prices) remain high, even without a clear escalation or de-escalation. If energy and trade flows recover in line with our baseline, we would expect the Dollar to resume its shallow depreciation trajectory and some prior themes may re-emerge.

A de-escalation in energy risks should provide a bigger tailwind to economies and asset markets in the rest of the world; even as the abrupt back-and-forth in US security policies keeps concerns about policy uncertainty elevated and maintains the trend towards diversification. While current account surpluses in China and North Asia may be smaller than before the oil shock, making for a less intense appreciation impulse, this should still keep the CNY on a gradual but sustained appreciation path.

Exhibit 7: Gradual CNY strengthening is limiting Dollar upside

Source: Goldman Sachs FICC and Equities, Goldman Sachs Global Investment Research

The pace of the CNY appreciation was running ahead of our forecasts, so the recent more gradual trend lower in the USD/CNY fixings in March has only really brought the pace back in line.

EM's uneasy resilience amid energy turbulence. 

Like other non-US DM counterparts, EM equities and fixed income assets have clearly underperformed the US through the Iran war shock.

Exhibit 8: EM equities have seen limited pressure in line with DM ex-US equities after a strong start...

Source: FactSet, Goldman Sachs Global Investment Research

Once again that underperformance is explainable, given the strong run of performance and fund inflows ahead of the shock, and the fundamental vulnerabilities from high energy prices in much of Asia and Europe. In general, emerging markets in Latin America and Africa on the right side of the energy terms-of-trade shock have fared relatively better.

Exhibit 9: ... with terms-of-trade an important differentiator across assets

Relative ToT move is relative to the US

Source: Bloomberg, Goldman Sachs FICC and Equities, Goldman Sachs Global Investment Research

Even here, markets with precious metals exposure, such as South Africa and Peru, have also seen big reversals as gold has fallen alongside risk assets. In the event of renewed escalation or a firmer pivot from inflation to growth concern, further and broader EM underperformance is a risk, given the still resilient performance across EM credits (where widening from very tight levels is still limited) and EM equities (which are still outperforming the US by 7%-8% ytd).

Across currencies as well, a pivot to growth concerns should finally lead to stronger returns across G10 safe havens such as the Yen and Swiss Franc, and lead to relative EM FX underperformance. A swifter de-escalation in oil prices should see the sharpest moves in local markets like South Africa and Hungary given the pressure (and upcoming elections) there. In the intermediate scenario, where escalatory tails are crimped but energy prices remain high, we would continue to expect underperformance in South and Southeast Asian markets like India and Philippines (where there are few offsets to the damaging impacts of the energy shock), and would focus on energy producers such as Brazil or Colombia for relative resilience.

Hedging the downside and upside. 

Hedging supply shocks is always challenging, as bonds as well as equities come under pressure. Oil supply fears also disrupt other traditional cross-asset hedges: JPY has faced headwinds from rising global rates and a hit to the terms of trade, while gold has suffered from a mix of heavy positioning and more hawkish monetary policy. So far, it has been most effective to hedge either directly in the underlying assets or in oil, the source of the shock. But longer-dated equity volatility has also continued to rise and, unlike shorter tenors, has exceeded the levels seen in all recent shocks except April 2025.

Exhibit 10: Implied volatility still below 'Liberation Day' highs, but longer-dated volatility has risen more clearly

Source: Goldman Sachs FICC and Equities, Goldman Sachs Global Investment Research

Even in our base case, long-term equity volatility is likely to drift higher over time. The pairing of selective asset longs with long positions in SPX volatility still appears to be an appropriate combination even after the energy risks fade.

A big question is whether positioning for lower rates will be more protective going forward, even in the face of any fresh oil shocks. Although we think yields are likely to settle lower over time under a range of scenarios, we would not be confident that bonds will be immediately protective in a more adverse oil scenario. But they should be protective against other shocks and yield downside (including jointly with equity downside) looks attractive against those broader risks. Positioning for relief through options is always more complicated given that near-term implied volatility usually resets sharply lower. But upside call wings in US and European equities (and European FX), while expensive, are not as rich as in many past drawdowns.

If we are right that upside in a potential recovery may be capped by the same worries that dominated before the Iran war shock, call spreads would also be easier to justify.

Attractive asymmetry in rates, balanced with energy exposures.

We think the asymmetry in rates markets is what has shifted most clearly through the war.

Particularly for those who can wear near-term volatility, we think it is compelling to add front-end longs or extend duration within portfolios.

And it is possible to sell puts on front-end rates in Europe and the UK with breakevens of multiple rate hikes.

Exhibit 11: Market pricing of Fed and ECB looks high relative to both our baseline and average forecast paths

Source: Bloomberg, Goldman Sachs FICC and Equities, Goldman Sachs Global Investment Research

Hedges based on deeper downside in rates (or related assets like USDJPY) or the joint scenario of lower rates and lower equities may also be worth adding for medium-term risks.

In equities, credit, and FX, the pricing is less distressed and still more dependent on which paths we take from here. When the distribution of outcomes is wide, the priority for investors is often about maintaining a posture that makes it possible to take advantage of bigger dislocations. While the first leg of any relief will probably favor those assets that have been hardest hit (largely in Europe and North Asia), US equity upside (SPX and NDX) also screens well given cheaper optionality.

Even if non-US outperformance resumes, the mix may be different from the start of the year. So over the medium term it may make sense to look to add risk in assets that benefit from structurally higher energy prices (including Brazilian equities and FX, AUD and some industrial cyclicals), which should also work in scenarios where tails are less prominent but full resolution is still some way off.

Against this, we think scenarios where growth slows sharply, including a larger oil shock, are still the main vulnerability for markets.

As markets relax a little about those risks, we think it makes sense to maintain, and possibly add to, positions that would protect against those deeper downside outcomes in equities, credit, and cyclical FX; and we continue to like positioning for higher long-term equity volatility.

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