Yesterday Donald Trump told the FT’s Ed Luce that his “preference would be to take the oil” in Iran. Markets in Asia opened in a foul mood last night. So it seems likely we are in for another volatile week in markets for everything from oil to stocks to volatility itself. Hopefully US retail sales and employment reports, which both land in the coming days, will lend stability rather than the opposite. Good luck out there

This is the message we wake up to from the FT’s correspondent from across the pond.

Have we over-reacted – Robert Armstrong thinks we have.

Short rates have overshot

The two-year Treasury yield — which I am contractually obliged to describe as “the policy-sensitive two-year Treasury yield” — fell a bit on Friday, which struck me as a sign of sanity returning. Short rates have gone too far:

When the war started, the market expected at the very least one and probably two Federal Reserve rate cuts by the end of this year. Those cuts have been erased from the market’s implied forecast. What is more, the market now prices in a one-in-five chance of a 25 basis point rate increase this year. Hence the leap in the two-year yield.

All this despite the fact that, back in central banking 101, we were taught that the correct response to a supply shock in energy is to leave monetary policy unchanged. Central banks cannot print oil, and higher energy prices already have a dampening effect on growth. Tightening just kicks the economy while it’s down.

There is an important addendum to this rule, though. Energy prices are so visible and relevant to consumers and businesses that watching them rise might create expectations of future, broad-based inflation. These expectations might encourage workers to demand wage increases and businesses to push up prices to protect margins, leading to an upward spiral. So the playbook says that when energy prices rise, bankers should stand up very straight and talk about how rates will be increased if necessary. This is what developed world central bankers have done.

Responding to this official posturing by taking out the two expected rate cuts would have been overkill — but for the fact that US inflation was about a percentage point above target, and stuck there, before the war began. The war may have scared some of the irrational optimism out of the market. But now things have gone too far.

If expectations do threaten to break containment, the Fed can act quickly. As of now, there is not even a whisper of this. Indeed, market-implied expectations for medium-term inflation are signalling that growth is a bigger worry (with oil and longer-term rates rising at the same time, the market may be on to something). Here are five-year expectations for the period starting five years from now:

One might argue that failure to raise rates in the face of a supply shock was what caused the inflation to run riot in 2021 and 2022. But the circumstances could not be more different now: nominal and real rates are starting from a higher point, and the labour market is stagnant where it was red hot back then. Alternatively, one might make the case that once the market starts to price in rate hikes, even for dumb reasons, the Fed has to deliver them, or face a loss of credibility which would invite higher inflation expectations. Perhaps, but the first line of defence for the Fed should be clear communication, not capitulation.

The overshoot in short rates could very well be a fleeting artefact of hurried repositioning by speculators. Lots of funds were long two-year bonds as a hedge for long positions in the S&P 500 (a trade, I regret to inform you, referred to as “twos and spoos.”) Neither side of the trade has worked, which may have forced everyone to rush from one side of the sailboat to the other.

If the last month has taught us anything, it is that things can always get worse. Given what we know right now, though, short rates look too high.

Armstrong