- The energy shock risk morphing into a fiscal shock.
- March PMI data to offer early read on how the war is beginning to filter through the economy.
- Norges Bank poised to keep rates on hold and scrap its easing bias.
Last week, all central banks shifted hawkish with the energy shock pushing inflation risks back to the forefront. As a result, interest rate expectations adjusted higher. US rate cut bets over the next twelve months have been priced out, while in most other advanced economies additional rate hikes have been priced in.
Interest rate differentials between the US and other major economies still anchors the DXY index within a 96.00-100.00 range. But until we reach peak fear around the energy shock, USD risks remain skewed to the upside driven by dollar funding needs in periods of financial market stress.
No energy reprieve and no central bank relief is a brutal combo for risk assets. CAD and NOK remain good hedges against a more persistent energy price shock. Both Canada and Norway get the terms of trade boost and have fiscal space to absorb some of the growth drag to domestic demand.
From Energy to Fiscal Shock
A key risk facing financial markets is that the energy shock morphs into a fiscal shock as higher borrowing costs collide with already stretched public finances. Longer term sovereign bond yields have pushed higher since the start of the Iran war driven by a toxic mix of rising inflation expectations, an upward repricing in central bank rate path, and growing fiscal concerns. Upward pressure on government bond yields will add to existing fiscal strains as rising debt is compounded by higher interest expense.
At the same time, fiscal shocks could be amplified because sovereign debt is increasingly held by hedge funds (more details here). Unlike banks or ‘real money’ private investors (pension funds, insurance companies, and asset managers), hedge funds are leveraged and highly liquidity driven. They rely on short-term secured borrowing (repo financing) from bank dealers to finance their investments. In periods of stress, funding can dry up, making fiscal shocks translate into faster, larger, and more correlated market moves.
War Trumps Data
This week, the S&P Global March PMI data (US, Eurozone, and UK on Tuesday. Australia and Japan on Monday) will offer an early read on how the war is beginning to filter through the economy. Meanwhile, the February CPI prints (Japan on Monday, Australia on Tuesday, and UK on Wednesday) will capture the pre-shock inflation backdrop.
On Thursday, the Norges Bank is seen leaving the policy rate unchanged at 4.00% (fully priced) and scrap its easing bias. The focus will be on the March Monetary Policy Report (MPR) and the extent of the upward revision to the bank’s policy rate projection. The December MPR implied a 25bps rate cut to 3.75% by Q4 2026, followed by 50bps of additional cuts by end-2028. Rate cuts are now likely off the table and instead give way to rate hikes. The swaps curve price-in over 50bps of hikes in the next twelve months.
In emerging markets, we expect central banks in Chile, Hungary (both Tuesday), Mexico, and South Africa (both Thursday) to deliver hawkish holds. Over the next twelve months, the swaps curve price-in 40, 138, 111, and 107bps of rate increases in Chile, Hungary, Mexico, and South Africa, respectively.
