Oil prices have soared, and the U.S. dollar has surged as expectations grow that central banks worldwide may delay or even reverse interest rate cuts.
The U.S. dollar is experiencing its largest two-day rally in nearly a year, driven by inflation concerns and heightened safe-haven demand amid escalating conflict involving Iran. On the evening of March 3, the U.S. dollar index rose approximately 0.7%, marking its strongest consecutive performance since last April. As traders scaled back their expectations for interest rate cuts, the yield on the 10-year U.S. Treasury note increased by 7 basis points, reaching its highest level in three weeks.
The expansion of Middle East conflicts has pushed energy prices higher, boosting the dollar as inflation expectations spiral. Crude oil prices surged above $85 per barrel for the first time since July 2024, while European natural gas prices jumped more than 40%, reaching their highest level since 2023. Against this backdrop, traders are reducing their bets on Federal Reserve rate cuts before the end of the year. Money markets are now pricing in 37 basis points of Fed rate cuts this year, down from 60 basis points last Friday.
The selloff in European bonds intensified as Middle East turmoil drove up energy prices, and a senior central bank official warned that a prolonged conflict could lead to stagflation in the eurozone. The prospect of renewed inflation has led traders to assign a more than 60% probability of a European Central Bank rate hike this year. Just last Friday, they had priced in a 40% chance of a rate cut.
Europe, which relies on imports for almost all its oil and most of its natural gas, appears particularly vulnerable due to the escalation of conflict involving Iran. Market movements have sparked concerns of a repeat of 2022, when energy price shocks following the Russia-Ukraine conflict proved more persistent than initially anticipated.
Analysts noted that soaring energy prices pose significant upside risks to eurozone inflation and downside risks to growth. This stagflationary backdrop could complicate the European Central Bank's policy outlook. Franklin Templeton's Chief Investment Officer for Fixed Income, Sonal Desai, stated that Europe appears much more vulnerable, similar to the situation in 2022.
European Central Bank Chief Economist Philip Lane warned that a protracted Middle East conflict could lead to a sharp spike in energy-driven price growth and a significant decline in output. Data released on Tuesday underscored this threat, showing eurozone inflation unexpectedly accelerated, supporting the ECB's cautious stance on interest rates.
According to Bloomberg Economics forecasts, in the UK, if the surge in oil and gas prices persists, this week's spike could increase inflation over the next year by 0.4 percentage points. This would push headline inflation to 2.4% by year-end, rather than the Bank of England's current expectation of 2%, delaying the return to target levels until 2027.
Citigroup rate strategist Jamie Searle commented that uncertainty about how energy price increases will affect inflation expectations could raise the threshold for near-term rate cuts.
Amid the impact of conflict involving Iran and inflation concerns, European stock markets extended their declines on the evening of March 3, with widespread selloffs across the board. Oil prices continued their sharp rise as reports indicated that Iraq began shutting down production at the Rumaila oil field after storage facilities reached capacity.
