Curb your enthusiasm
Will the relief rally — and fragile Iran ceasefire — hold?
Bottom Line
The recent surge in energy prices and the uncertainty of the military conflict in Iran combined to significantly impact two key economic metrics this morning. The University of Michigan’s Consumer Sentiment Index plunged to a record low (dating back to 1978) of 47.6 in April, down from 53.3 in March. In addition, nominal retail CPI inflation leapt by a four-year high of 0.9% month over month (m/m) in March, triple February’s 0.3% m/m increase. This was largely due to higher energy prices, as retail gasoline inflation at the pumps surged 21% last month, its largest gain since 1967. As a result, nominal CPI soared by 3.3% year-over-year (y/y) in March, up from 2.4% in February. Core CPI inflation, which strips out volatile energy and food costs, had moderated from a 40-year high of 6.6% y/y in 2022 to a nearly five-year low of 2.5% in February 2026, but it ticked up to 2.6% in March.
The combination of the increase in inflation/energy prices and plunging consumer sentiment will likely contribute to slower economic growth near term. To that point, the Atlanta Fed’s GDPNow tracking estimate for the first quarter of 2026 has declined sharply from 3.2% in early March to 1.3% now.
Major investor FOMO Yet, investors appear fearful about missing out on another major rebound in risk assets — such as the powerful Liberation Day rally a year ago, in which the S&P 500 soared 45% over 10 months. As a result, they seem willing to look through the current fog of war with Iran and its potentially negative near-term impact on the economy and financial markets.
Operation Epic Fury against Iran is six-weeks old, and the S&P dropped nearly 10% from its record intraday high of 7,002 in late January to its March 30 low. But over the past eight trading days — perhaps as investors began to anticipate a cease fire — stocks have rebounded by 8%. They now sit only 2% below record highs.
A sharp equity market sell-off usually sparks a flight-to-safety rally in benchmark 10-year Treasury yields. But yields soared from 3.95% at the end of February to 4.45% in late March, as bond investors seemed more focused on the risk of higher inflation. Along with the recent rally in stocks, however, bond yields have fallen to 4.30% over the past fortnight. Finally, the volatility index (VIX) spiked from 18 in late February to 35 on March 9 and has since round-tripped back to 19 today. But is this recent strength in stocks, bonds and the VIX sustainable?
Fed likely on hold The Federal Reserve’s dual mandate at present is clear. The jobs report in March was solid across the board, but this morning’s inflation was elevated due to the military conflict with Iran and the spike in oil prices. Given the ongoing leadership transition at the Fed, we do not expect any monetary policy changes in either direction for the next few meetings. We believe policymakers will look through the temporary surge in inflation and resist the urge to hike rates, while the recent strength in the labor market precludes the immediate need to cut rates. With the upper band of the fed funds rate at 3.75% and the yield on two-year Treasuries (which many equate to the fed funds rate) at 3.80%, the Fed can safely adopt a patient wait-and-see attitude.
Art of the Deal or TACO Tuesday? This past Tuesday, less than 90 minutes before his own self-imposed deadline to obliterate Iran militarily, President Trump agreed to a two-week ceasefire with Iran to negotiate a settlement. Vice President Vance will lead the US negotiating team in Islamabad, Pakistan in meetings commencing Saturday.
The US and ally Israel have destroyed much of Iran’s naval, air force and communications capabilities over the past six weeks. But Iran has managed to keep the Strait of Hormuz closed due to its strategic use of naval mines, missile drones and small attack boats. Some 20% of the world’s oil flows daily through this critical chokepoint. As a result, crude oil prices (West Texas Intermediate, or WTI) spiked 85% over the past six weeks, from $65 per barrel at the end of February to $118 this past Tuesday, just prior to announcement of the ceasefire. Oil then dropped by 22% to $91 per barrel on Wednesday. Lagging gasoline prices have risen 40% from $2.98 per gallon at the end of February to a four-year high of $4.15 today. While energy prices typically rise more quickly than they recede, we could see crude oil ease to $75 by year-end.
Wide chasm in demands The US position entering the negotiations may include: Iran must agree to immediately reopening of the Strait; to never pursue nuclear weapons; to dismantle its nuclear facilities; to surrender all highly enriched uranium to the International Atomic Energy Agency; to suspend its ballistic missile production; and to stop funding its regional proxies (Hamas, Hezbollah and the Houthis). Iran appears to have set a red line at a recognition of its sovereignty over the Strait, war reparations; the right to enrich uranium; the end to international sanctions; and allowing protection to its proxy groups.
Strait of Hormuz is Iran's best leverage Up until recently, the Strait of Hormuz was an international waterway, through which 140 ships sailed freely each day. But Iran has very effectively used its geographic and tactical advantages in the region to deter freedom of navigation. It demands a toll of $1 per barrel for safe passage through the Strait, paid with cryptocurrency. The most common vessel for moving oil from the Middle East is a Very Large Crude Carrier (VLCC), each of which can carry two million barrels of oil. Each barrel of oil contains 42 gallons, which translates to a relatively de minimis toll of 2.5 cents per gallon. But at $2 million per ship, that’s more than $100 billion in tolls that Iran would collect in a year, which they could use to rebuild their nuclear infrastructure. There is an estimated backlog of more than 1,200 of these VLCC’s in the Persian Gulf right now.
Clearly, then, Iran’s demands are objectionable to the US, Israel, Europe and their Middle East allies. So, while the two-week ceasefire could be extended to continue negotiations, the US and Israel could alternatively resume hostilities, in which case financial markets may be positioned too bullishly.
Iran playing for time But Iran’s negotiating tactics are legendary. Aside from reading Trump’s “Art of the Deal,” Iran has seemingly also studied North Carolina basketball coach Dean Smith’s four-corner stall. With the midterm elections only seven months away and gas prices at a four-year high, Iran believes that Trump wants to move on quickly from this morass, which potentially provides the theocracy with a window to survive.
Read more about our views and positioning at Capital Markets.