Deutsche Bank warns markets are pricing the Iran conflict inconsistently across equities, rates and credit, with long-run inflation faith looking increasingly difficult to sustain.
Summary:
- Deutsche Bank notes a clear repricing across markets since the Iran conflict began, but identifies significant inconsistencies across asset classes and regions, according to the bank’s research note
- US Treasury yields have closely tracked oil prices since the conflict began, but equities diverged after an initial correlation, with equities appearing to price in a temporary shock while rates markets price in a more protracted conflict, per Deutsche Bank
- Central bank pricing is described as inconsistent on a relative basis, with markets expecting the Federal Reserve to hold rates for the next 12 months while simultaneously pricing in up to three ECB rate hikes by March, despite the US having stronger growth and higher core inflation, according to the note
- Both high-yield and investment-grade credit spreads in the US and Europe are tighter now than before the Iran conflict began, despite an energy shock, weaker growth expectations and a hawkish shift in central bank pricing, per Deutsche Bank
- The bank warns that markets have retained a remarkable degree of faith in longer-term inflation remaining anchored around target, despite another energy shock, several years of above-target inflation and a persistent historical upward bias in price pressures, according to the research note
Financial markets have repriced significantly since the Iran conflict began, but the signals they are sending are contradictory and in several cases very difficult to reconcile, according to a research note from Deutsche Bank. The bank has identified a series of inconsistencies across equities, fixed income, credit and central bank pricing that suggest investors have not yet converged on a coherent view of how the conflict will evolve or what it will mean for inflation and growth.
The most striking divergence Deutsche Bank highlights is between equity markets and rates. Since the conflict began, US Treasury yields have moved in close alignment with oil prices, suggesting bond markets are pricing in a sustained inflationary shock consistent with a protracted conflict. Equity markets told a similar story initially, but have since decoupled, implying that stock investors have settled on a view that the disruption will prove temporary. Both assessments cannot simultaneously be correct, and Deutsche Bank’s note frames the gap as a live tension rather than a resolved debate.
Central bank pricing adds a further layer of contradiction. Markets are currently positioned for the Federal Reserve to keep rates on hold for the next 12 months, while also pricing in the possibility of the European Central Bank hiking rates as many as three times by March. Deutsche Bank finds this relative pricing hard to justify given that the US economy is running with stronger growth and higher core inflation than the eurozone. The implication is that one side of that trade is mispriced, with consequences for dollar assets and rate-sensitive sectors if the gap corrects.
In credit markets, the picture is arguably the most counterintuitive. Both high-yield and investment-grade spreads in the US and Europe are currently tighter than they were before the Iran conflict began. That is a compression in perceived credit risk at a moment when an energy shock is bearing down on corporate costs, growth forecasts have been revised lower, and central bank pricing has shifted in a more hawkish direction. Deutsche Bank does not offer a definitive explanation for the tightening but presents it as evidence of broader market inconsistency.
Underlying all of these anomalies, the bank argues, is what it characterises as a remarkable and perhaps unwarranted degree of faith among investors that long-run inflation will remain anchored around target. That faith has persisted through another energy price shock, a prolonged period of above-target inflation stretching back several years, and what Deutsche Bank describes as a persistent historical tendency for price pressures to surprise to the upside. Whether that confidence is justified or represents the final piece of a mispricing that will eventually correct is, the note implies, one of the more consequential open questions facing markets right now.
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The inconsistencies Deutsche Bank has identified point to markets that are still in the process of digesting a conflict shock rather than having reached a stable new equilibrium, which itself creates trading risk. The divergence between equity and rates pricing is particularly pointed: if bond markets are correct that the Iran conflict is protracted and inflationary, equity valuations built on a temporary-shock assumption face a material correction. Credit spread tightening, against a backdrop of an energy shock and downgraded growth, suggests investors are either complacent or front-running a policy pivot that central bank pricing does not yet support
