Stocks have reached record highs, but investors may be underestimating a significant factor in the changing market dynamics following the ongoing conflict in Iran. Tom Graff, the chief investment officer at Facet, emphasized that the implications of the war on Federal Reserve policy should not be overlooked. He noted that many investors are not fully considering how the current geopolitical tensions affect monetary policy. “The fact that we’ve taken two Fed cuts out of the interest pricing for the rest of this year is pretty meaningful for the stock market,” he stated.
Earlier this year, markets anticipated as many as three rate cuts by the Fed, but that outlook has dramatically shifted. Investors may now expect just one cut or potentially none at all. This change in sentiment aligns with the recent appointment of a new Fed chair; Kevin Warsh, who was nominated by former President Donald Trump, has taken on a more hawkish stance than many had predicted during his congressional testimony, complicating the outlook for future interest rates. A recent analysis from CME’s FedWatch tool reveals that approximately two-thirds of investors now believe rates will remain stable through the end of the year, while about 32% still expect cuts.
The war in Iran has significantly influenced these shifting expectations for rate cuts, particularly with the resurgence of inflation fears associated with skyrocketing energy costs. Oil prices have surged since the conflict began, currently hovering around $96 per barrel, which is over 40% higher than prewar levels. President Trump expressed surprise that oil had not escalated to the anticipated $200 mark per barrel.
This change in expectations is particularly critical for the stock market, especially since several major Wall Street firms were banking on Fed cuts as part of their optimistic projections through 2026. Graff warned that investors might be overlooking how constrained the Federal Reserve has become due to the economic impact of the Iran war. He pointed out that while the economic data might seem stable, rising oil prices create a dilemma: the Fed is hesitant to cut rates in an environment of high inflation.
Mark Zandi, the chief economist at Moody’s Analytics, shared similar sentiments. He indicated that, at the beginning of the year, GDP was expected to benefit from fiscal stimulus and more accommodative Fed policies. However, he now suggests that even if the conflict concludes and oil prices decrease, the economic fallout will likely prevent any boost to GDP or recovery in job growth, potentially worsening unemployment and increasing recession risks.
Investing veteran Mohamed El-Erian has also indicated that the aftermath of the price shocks stemming from the Iran conflict will compel global central banks to maintain higher policy rates for an extended period. He characterized the situation as more than just a price shock, as it entails a second-round adverse demand shock, which could lead to broader financial instability.
El-Erian highlighted that central banks face a challenging path forward, suggesting they will need to navigate complex decisions and ask themselves, “Which is the least unrecoverable mistake we can make?” He noted that the Fed is caught in a particularly tough spot, tasked with balancing its dual mandate of promoting maximum employment and stabilizing prices amid this uncertain landscape.
