Trading Desk Talk

Backwards

Rascal Flatts, a Tennessee band, sang that when you play a country song backwards, you get everything— your house, dog, best friend, truck, hair, and first/second wife—back. A similarly happy reversal happened last week, as investors rewound their forecast of a rate hike in 2026 to again bet on cuts from the Federal Reserve over the balance of 2026 (Figure 1).

The bond rally comes after weeks of selling that was driven by surging energy costs and rising concerns over potential central bank interest rate hikes. Those fears were somewhat alleviated last week: The market shifted focus back toward slowing economic growth, thereby lowering the probability that central banks will need to adopt an aggressively hawkish stance to control inflation.

“Investors have focused on the potential risks to global growth related to events in the Middle East, rather than simply trading the conflict through the lens of an inflationary impulse,” said Ian Lyngen, head of U.S. rates strategy at BMO Capital Markets. On this point, Fed Chair Jerome Powell said last week that “longer-term inflation expectations appear to be in check, but that the central bank is carefully monitoring them as it assesses the effect from the U.S. and Israel’s war against Iran.”

Powell added that officials may need to respond to the impact from the conflict, but not yet. “We don’t know what the economic effects will be. We do think our policy is in a good place for us to wait and see.” The market took these words to imply that policymakers are viewing the war as a transitory shock that will not have structural effects on oil and, therefore, on longer-term inflationary pressures.

Exogenous supply shocks are often attributed to natural disasters. In the case of an oil shock, for instance, hurricanes in the Gulf of Mexico and America can create one, but so too can wars. Unfortunately, the duration of the Iran war is a major unknown. “The tendency is to look through any kind of a supply shock, but a critical aspect of that is you have to carefully monitor inflation expectations,” Powell said. “I’m reluctant to say anything that suggests that we’re dismissive of the risk. But we’re looking for connections to the banking system and things that might result in contagion. We don’t see those right now.”

President Trump suggested last week that he’s keen to exit the conflict sooner, rather than later. “We’ll leave because there’s no reason for us to do this [war],” he told reporters. In a primetime speech after, however, Trump did little to define a timeline for ending the war, suggesting the possibility of an accord alongside the prospect of further escalation.

It’s hard to say, based on conflicting messages coming out of the U.S. and Iran, where any prospects for a ceasefire stand. If the war ends tomorrow (or soon), Powell and company will have more reason to believe that short-term spikes in oil can rewind, and with them, inflation expectations. To some extent, the market has already priced the current damage to production capacity. If a ceasefire starts immediately, future repair to the oil infrastructure would be likely—and with it, increased supply and presumably lower prices, followed by lower inflationary concerns.

As of now, the market is still pricing in a risk premium for near-term delivery of Brent crude oil. The front month, June Brent crude, is trading around $107/barrel, while July is about $10 cheaper (Figure 2). When supply is tight, front-month contracts tend to rise more quickly than in the future months due to the desire for flexibility to meet demand—a development that’s playing out in today’s market. While it’s normal for future months to trade at a slight concession (think storage costs), the market is quite extreme now.

Nevertheless, the current pricing in oil contracts suggests that war-related volatility in this market may abate by Autumn 2026 and that prices may continue to drop throughout 2026 (December Brent crude futures are trading near $80/barrel). The heavy caveat is that nobody knows if/when/what an agreement between warring parties will look like.

If the war drags on, however, the opposite may be true. Further damage to production capacity will reduce supply, potentially for years, which would create long-term inflationary pressures—and with them, tighter monetary policy most likely.

Christine Lagarde, president of the European Central Bank, made this point during a G-7 meeting last week, after U.S. Treasury Secretary Scott Bessent downplayed the damage caused by weeks of fighting and suggested the economic fallout from the Iran war will be short-lived. Lagarde aggressively countered Bessent, by stating that the effects would be felt for a long time because so much infrastructure has already been destroyed.

A few days earlier in an interview with The Economist, Lagarde said: “We are facing a real shock that is probably beyond what we can imagine at the moment.” When it comes to energy extraction, processing, and distribution, “too much has already been damaged and there is no way that it can be restored in a matter of months,” she added.

The views of Lagarde and Bessent are undoubtedly shaped by the contrasting realities of a U.S. that is largely energy self-sufficient and a Europe that is a big energy importer. The ECB’s “severe” scenario—based on significant further destruction of infrastructure in the Middle East and acute energy-supply disruptions persisting until late 2026—has European inflation peaking at 6.3%. While no Fed official has discussed scenario analysis publicly, long-lasting Middle East energy disruptions would clearly have less impact on inflation in the U.S. than in Europe.

The tipping point now rests between investor sentiment that views the Iran war as simply a defining factor in the inflation outlook or as a major deterrent to global growth. Taking words at face value, military operations seem likely to intensify in the near-term, which risks greater destruction of energy production capacity— which, in turn, will lower the bar for energy price spikes and rising inflation jitters.

The likely result of this sequence is higher yields, at least until a deal to stop fighting is reached. For those in the mortgage business hoping for lower rates, we can only hope the market keeps playing backwards, Rascal Flatts-style.

FROM THE DESK

Agency CMBS — — Investor sentiment was cautious last week. The war narrative continues to weigh on the minds and sentiment of the market. Dealer balance sheets remain full, which may put pressure on spreads, but with lighter origination in both the Ginnie Mae and Fannie Mae front, spreads were flat, week over week.

Municipals — AAAA tax-exempt yields moved lower across the curve, week over week. Deals that came to market last week benefited from a holiday-shortened week, with primary new issuance cut in half compared to previous weeks. Just over $50 billion of new issue volume came to market during March. Investors put $923 million into muni bond funds last week, bringing year-to-date inflows to $16.96 billion. While overall inflows turned positive, high-yield funds had a third straight week of outflows, with $173 million withdrawn.

The information contained herein, including any expression of opinion, has been obtained from, or is based upon, resources believed to be reliable, but is not guaranteed as to accuracy or completeness. This is not intended to be an offer to buy or sell or a solicitation of an offer to buy or sell securities, if any referred to herein. Lument Securities, LLC may from time to time have a position in one or more of any securities mentioned herein. Lument Securities, LLC or one of its affiliates may from time to time perform investment banking or other business for any company mentioned.