Monthly Economic & Interest Rate Outlook (MEIRO) – Crude oil remains the dominant force

Key updates: crude oil continues to drive the economic narrative globally. While we see the Federal Reserve (Fed) hiking again, we don’t expect it to derail economic growth.

Economic environment:

• Crude oil has forced a reset across the board, highlighting the critical role petrol plays in the global economy – from transportation fuel to industrial raw material for plastics, fertilizers, clothing, and medicines. Alas, the recent price resurgence—staying above $90/barrel in the U.S.—has upended the inflation progress and boxed in the Fed.
• Fed rate hikes shouldn’t materially alter near-term economic growth. That said, higher interest rates cool growth on the margin, as do higher crude oil prices.
• While consumers are still spending, that dynamic won’t persist indefinitely. Moreover, an increasing share of spending is at the pump and less elsewhere, particularly for those with low-to-moderate incomes as gasoline accounts for a much larger portion of their budgets.

Federal Reserve outlook:

• Like many central banks, the Fed was compelled to respond to oil-induced inflation last month.  Given the resurgence in oil prices, we see limited room for inflation to abate; thus, we’re expecting another Fed rate hike in December. The Fed remains intensely focused on the inflation side of its dual mandate and has demonstrated it stands ready to respond.
• Conversely, because inflation is largely being driven by the crude oil supply shock, a pullback in oil prices could quickly alleviate price pressures, much as it did in June and July. In that scenario, the Fed could deliver one more rate hike before pausing to reassess. But that’s a rather big “if” and not our base case.

Impact on yields:

• Traders have pared bets that the Fed will consistently raise policy rates over the next year and market expectations are currently more aligned with our view. The 2-year U.S. Treasury yield is roughly 1.35% above pre-conflict levels. We continue to see downside risk to front-end yields if inflation pressures ease and the market scales back expectations for further tightening.
• A more meaningful decline in yields beyond 2-year maturities is likely predicated on reaching a durable peace agreement in the Middle East. Fiscal concerns and resilient economic activity will keep the long end relatively sticky and limit the downside in U.S. yield.

• The U.S. economy continues to plod through the uncertainty caused by the Iran War and the subsequent spike in gasoline prices. Important drivers – such as artificial intelligence (AI)-led tech investment – have taken the baton as a key growth engine. Yet, growth feels uneven given volatile gasoline prices and a lack of sustained hiring.
• Crude oil’s rollercoaster ride continues. Our base case is that the price of crude oil—and diesel more importantly—will remain elevated through much of 2027.
  • Although the price level of diesel and gasoline is important, the speed of price changes often have a greater impact on economic growth than the level itself.
  • Recent fuel tax rollbacks are temporarily reducing prices at the pump. In addition to the 15 state-level fuel tax rollbacks, the federal government is now allowing so-called off-road "dyed" diesel for highway use and suspended the 24.4-cent-per-gallon federal tax for the remainder of 2026. These moves are slowly trickling down to the pump, but the national averages for gasoline and diesel remain elevated.
• Uncertainty remains a downside risk – for trade and supply chains, for Fed policy, etc. That widens the range of potential economic outcomes.
  • As we noted here previously, the Iran conflict casts a long shadow over the economic outlook. The extended delay in fully reopening the Strait of Hormuz heightens the risks as inflation is seemingly tied to an Iran deal. It also means inflation will continue to dog the Fed until there is a deal.
  • The Fed rate hike alone doesn’t materially alter our near-term economic outlook. Market rates were already elevated, with the 10-year U.S. Treasury yield above 4% for the past two years and 30-year mortgage rates above 6% since mid-2022. Still, higher-for-longer interest rates and higher crude oil prices restrain economic growth.
• Three positive drivers remain intact – tax incentives for consumers and businesses, tariffs are lower than in ’25 (along with tariff refunds), and continued investment in AI and technology spending. On the first point, personal federal tax refunds ended up 18.3% above last year. Those are a very real boost to consumers, along with a substantially reduced bill for high-income taxpayers. On the second point, the effective U.S. tariff rate has dropped to 11.0% from roughly 15.0% at the end of 2025.
• Employment trends remain inconsistent. Job growth remains uneven, with hiring swinging from month to month rather than following a consistent trend. For instance, payroll growth stumbled in September after a surprisingly strong August report and three consecutive soft readings during the summer. Meanwhile, a shrinking labor force, more than labor market strength, continues to limit a meaningful rise in the unemployment rate.
• Conversely, reshoring will continue to support growth, but don’t expect big job growth within manufacturing. Most of the new plants being built in the U.S. are heavily automated and mechanized. Indeed, there will initially be construction-related work, along with ongoing logistics jobs, but reshoring won’t meaningfully boost hiring within manufacturing.

• We expect an additional quarter-point hike before year-end 2026 and two more rate hikes in 2027. Oil-induced costs filter into the rest of the economy, inflation readings have moved higher, and the Middle East conflict remains unresolved with no clear end in sight. Meanwhile, a steady labor market reduces near-term risks to the employment side of the Fed’s dual mandate, giving policymakers greater scope to address persistent inflation pressures.
• Base case scenario: We expect the prolonged “no-deal” environment in the Middle East to continue. Against that backdrop, U.S. Treasury yields are likely to remain elevated as the Fed continues to raise its policy rate and oil prices remain high. Short-dated yields should remain near current levels with multiple rate hikes already priced in but will be very sensitive to energy prices. Longer-term inflation expectations have moved higher since June but are well below levels seen at the onset of the conflict. If expectations remain fairly anchored, increases in the 10-year yield should be modest following this year’s substantial rise in real interest rates.
  • If shipping traffic improves, yield declines should be more pronounced in shorter-dated maturities, particularly if inflation risks moderate and reduce the need for further tightening. In this scenario, longer-dated yields would likely be spurred somewhat lower, too. However, U.S. fiscal imbalances, resilient economic growth, and robust government debt issuance may constrain their decline. As a result, the net result would be a return to steepening in the yield curve as longer-dated yields prove a bit “stickier.”
• A less favorable scenario would involve significant military re-escalation and more persistent inflation pressures, forcing the Fed to tighten more aggressively and swiftly than markets (or we) currently anticipate. Without a deal, inflation expectations could continue to rise alongside increased U.S. military spending, worsened budget deficits, and the potential for more government debt issuance. Higher borrowing costs would increasingly weigh on rate-sensitive areas of the economy, weakening the growth outlook for 2027. In this scenario, we would expect the yield curve to flatten further, and likely invert (i.e., short-dated yields rise more than longer-dated yields). An inversion is not inevitable, but a prolonged hiking cycle would increase those risks as tighter policy slows economic activity, with subsequent growth concerns restraining longer-term yields.
  • We see limited scope for a sustained decline in the 10-year yield meaningfully below 5.0% this year. Higher policy rates and persistent inflation risks are likely to remain at the forefront over the very near term. At the same time, we do not expect a significant rise in the 10-year yield from current levels. First, the equity market has repeatedly shown discomfort when the 10-year yield approaches 5.3% and has encouraged a flight-to-quality into areas like U.S. Treasuries. Second, higher policy rates should dampen inflation and growth expectations, helping alleviate upward pressure on interest rates by increasing demand for longer-dated U.S. Treasuries.
  • In shorter-dated maturities, yields have already positioned for additional Fed rate hikes. However, the 2-year yield would likely rise further if inflation remains above target because of persistently high energy and fuel prices.
• Borrowing costs: On balance, lending rates remain elevated alongside the sustained rise in interest rates. With the Federal Reserve expected to maintain a restrictive policy stance through 2027, we do not anticipate a meaningful improvement in borrowing costs over the next year, while elevated home prices remain an additional constraint on housing affordability.
• U.S. credit spreads have widened recently, with most of the move concentrated in lower-rated issuers that are more vulnerable to higher borrowing costs. If this widening migrates to higher-rated issuers, it will send a more concerning economic signal; however, that is not the case today. Current credit spreads remain consistent with ongoing U.S. growth. Last month, we shifted our outlook for high yield corporate bonds to more attractive as wider spreads and higher absolute yields created a compelling entry point. Higher starting yields support our constructive total return outlook, although widening in lower-quality credit reinforces the importance of issuer selection and credit surveillance.

• The Middle East conflict appears to be pulling in other countries like Saudi Arabia and Yemen. This widening conflict could lead to drastically reduced supply of crude oil, crimping global economic growth, especially in Asia and Europe.
  • As we are approaching to the 250-day mark of the Iranian conflict, no near-term resolution in sight and the Strait of Hormuz has curtailed for global trade.
  • Houthi rebels staged drone and missile strike to Saudi Arabia’s Riyadh airport killing a dozen travelers with over 300 critically injured. Houthi rebels also seized additional territory and nearby islands around the Bab al-Mandeb Strait, a critical waterway linking the Red Sea to global shipping routes.
• There is new round of talks in Miami with an aim to end the Russia-Ukraine war. President Trump announced a deal with Russia to waive certain sanctions in return for Russia significant amount of diesel fuel to global markets. 
• We expect a wider, volatile range for the U.S. dollar with a near-term upside bias. Weaknesses in Europe’s political landscape are becoming more apparent ahead of France’s 2027 presidential election, while Germany’s established parties continue to lose ground to the rising Alternative for Germany (AfD).
• The first round of the Brazil’s presidential election resulted a strong showing for Flavio Bolsonaro. The runoff is scheduled for Oct 25^th, 2026.

• A broader expansion or escalation in the Iran conflict, particularly regarding the Strait of Hormuz, could result in sustainably higher inflation by disrupting the global oil supply chain. That would push global interest rates higher and hamper global growth.
• Government funding, which lapses on December 11^th, is simmering in the background. But Congress appears more focused on the midterm elections. We anticipate that Congress will extend funding into early 2027. Of course, nothing will happen until after the election (aka the lame duck period).
• Continued trade uncertainty or new flare-ups, which would ratchet up uncertainty.
• While companies remain in “low hire/low fire” mode since 2025, a dramatic deterioration in the labor market would slow economic momentum.
• Global bond market participants initiate a “buyer’s strike” against government-issued debt in response to ongoing fiscal largesse, robust debt issuance, and mounting interest costs, thereby forcing U.S. and international yields (i.e., government borrowing costs) higher.
• Additional government dysfunction and the potential for policy gridlock to impede important legislation, such as federal budgets, the debt ceiling, and key confirmations. Democratic gains in the midterm elections could upend the current Republican mandate.
• Slower/sluggish global growth, primarily in China, Europe, and the United Kingdom.
• Political tensions abroad causing reduced demand for U.S. goods or travel to the U.S., with some countries actively avoiding American products.