Monthly Economic & Interest Rate Outlook (MEIRO) – Higher crude oil prices forcing a reset

Executive Summary

Key updates: From Main Street to the Federal Reserve (Fed), crude oil is driving the narrative. Although the Fed is 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—back above $100/barrel—has upended the inflation progress and boxed in the Fed.
• The Fed rate hike shouldn’t materially alter near-term economic growth. That said, higher interest rates cool growth generally on the margin, as do higher crude oil prices.
• While consumers are still spending, that dynamic won’t persist indefinitely. They’re spending more 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 (Fed) outlook:

• Like many central banks, the Fed was compelled to respond to oil-induced inflation.  Given the resurgence in oil prices, we see limited room for inflation to abate; thus, we’re expecting another Fed rate hike in December.
• Conversely, since inflation is mostly being driven by the crude oil supply shock, a decline in oil prices could quickly ease inflation, as seen in June and July. Accordingly, the Fed may hike once more and then reassess conditions. But that’s a rather big “if.”
• The Fed reinforced its independence with the September rate hike and projection of additional hikes, which should help dispel concerns about the Fed’s independence. As Chairman Warsh put it, the Fed is “staying in our lane” and setting policy based on economic conditions.

Impact on yields:

• Traders are currently pricing a more aggressive hiking by the Federal Reserve than we forecast. The 2-year U.S. Treasury yield is roughly 1.25% 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.
• The unresolved U.S.-Iran peace talks are keeping longer-term (>3 years) yields elevated and choppy. Fiscal and trade policy concerns will keep the long end sticky, but the scale of the recent move in rates creates notable downside risk to yields if a resolution removes further tightening from the table.

Key factors shaping our outlook

U.S. Macro – Oil's resurgence tests consumers, inflation, and the Fed

• 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 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.
• Uncertainty remains a downside risk – for trade and supply chains, for Fed policy, etc. That widens the range of potential economic outcomes.
  • Crude oil’s rollercoaster ride continues. 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% at the end of 2025.
• Employment trends remain inconsistent. For instance, the August monthly jobs report surprised to the upside in August after weaker prints for three straight months in May through July. However, the takeaway is that job growth remains uneven, with hiring trends oscillating from month to month rather than following a clear trajectory. While the unemployment rate dipped to 4.1%, the decline was more about a shrinking labor pool than labor market strength.
• 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.

U.S. interest rates & Federal Reserve

• We updated our view to anticipate an additional quarter-point rate hike through the end of 2026 as oil-induced inflation and a resilient economy have overtaken the case for an extended pause. Inflation expectations have moved higher over the last several months but remain well below the spike that was experienced at the onset of the Iran conflict. If inflation expectations remain well anchored, the Fed should avoid embarking on an extended rate hiking cycle.
• Base case scenario: We believe that peak tensions between the U.S. and Iran are behind us; however, the prolonged “no-deal” environment surrounding the Strait of Hormuz is dragging on. Against that backdrop, U.S. Treasury yields are likely to remain elevated as the Fed increases its policy rate and oil prices remain high. A full normalization of shipping traffic through the Strait of Hormuz would likely improve the inflation outlook and allow the Fed to be more patient. In this scenario, the 10-yr yield could decline into the 4.25%–4.5% range.
  • If shipping traffic improves, yield declines could be more pronounced in shorter-dated maturities given they’re currently positioned for a higher Fed funds rate. Over the past month, yields across the curve have moved higher as additional rate hikes have been priced into market expectations. If inflation expectations remain subdued with progress in the Middle East, short-dated yields should move lower. Longer-dated yields should 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 should be a return to steepening in the yield curve as longer-dated yields prove a bit “stickier.”
• A less favorable scenario would be if the conflict remains unresolved for an extended period, forcing the Fed into a prolonged rate hiking cycle. Without a deal, inflation expectations could move higher alongside increased U.S. military spending, worsened budget deficits, and the potential for more government debt issuance. This combination of elevated risks could keep interest rates elevated across the yield curve and increases the likelihood of further policy tightening. This likely result would be to push yields higher beyond 3-year maturities, particularly at the long end of the yield curve.
  • We believe the 10-year U.S. Treasury yield would find it difficult to sustainably breach the 5.0% threshold for three primary reasons. First, a prolonged conflict fuels greater global growth concerns, putting further downward pressure on yields. Second, the equity market has repeatedly shown discomfort in recent years when the 10-year yield approaches the 4.5%-5% range, powering a flight-to-quality into U.S. Treasuries. Evidence of this dynamic emerged recently as long-bonds have rallied this week when yields approached 5.0%. Third, the Fed’s September rate hike and potential for more hikes should help to rein in inflation expectations, particularly as investors maintain confidence in the Fed’s commitment to the price stability side of its dual mandate.
  • In shorter-dated maturities, we would expect yields to move only slightly higher from current levels, as much of the recent inflation concern has already been reflected in market pricing. While traders have positioned for three additional hikes (0.75%) through 2027, we believe that the bar for an extended rate hiking cycle remains high.
• Borrowing costs: On balance, lending rates continue to remain elevated along with the sustained rise in interest rates. With the Federal Reserve now expected to maintain a restrictive policy stance through 2027, we do not anticipate a meaningful decline in borrowing costs over the next year nor a catalyst for materially stronger growth. For instance, 30-year fixed mortgage rates should drift modestly lower, but home prices are a much larger challenge for housing affordability than mortgage rates.
• U.S. credit spreads remain tight amid the ongoing geopolitical tensions, driven by the strength of the corporate sector throughout the year. Current spreads still signal the market’s confidence in the U.S. economy and its companies. In March, as credit spreads approached their widest levels in almost a year, we upgraded our outlook for the high yield corporate bond sector from less attractive to neutral. Although they have tightened meaningfully, elevated absolute yields are supportive of constructive total return outlooks for investment grade and high yield corporate bonds.

Global and geopolitical

• Conflicts in the Middle East have drastically reduced the supply of crude oil, crimping global economic growth, especially in Asia.
  • The Iranian conflict has passed the 200-day mark, with no near-term resolution in sight and keeping the Strait of Hormuz closed. Drone strikes have shutdown Saudi Arabia’s East-West oil pipeline, which was the main route used to bypass the Strait of Hormuz during the blockade of the Strait.
  • In Yemen, Houthi rebels seized additional territory and nearby islands around the Bab al-Mandeb Strait, a critical waterway linking the Red Sea to global shipping routes.
• As winter approaches, the Russia-Ukraine war has intensified. Russia launched one of its largest air campaigns against Kyiv, while Ukraine continued striking infrastructure targets inside Russia. Attacks on Russian oil infrastructure are further reducing global refining capacity and straining global supplies of refined products.
• Robust U.S. growth relative to its peers and higher yields have boosted the U.S. dollar. We expect a wider, volatile range for the U.S. dollar with a near-term upside bias.
• The far-right Alternative for Germany Party (AfD) won a decisive regional election victory in Saxony-Anhalt, which is seen as a bellwether for broader German politics. Recent polling shows AfD has become the most popular political party, putting pressure on mainstream parties, particularly the Christian Democrats and Prime Minister Friedrich Merz.
• The key elections in 2026 are the U.S. midterms and Brazil’s presidential election. Market-friendly presidential elections in Colombia and Peru resulted in the election of Abelardo Espriella and Keiko Fujimori, respectively, which should result in greater cooperation within the Americas.

Risks to our outlook

• 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 at fiscal year-end on September 30th, is once again a pressing issue. But Congress appears more focused on the midterm elections and a stopgap bill rather than a long-term deal.
• 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.