Brent prices have now dropped from close to US$100/bbl down to almost US$80/bbl in the span of less than two weeks. However, over the same time span, the market has already come to the conclusion that much of the damage has been done, and the overall reaction function of rates to the geopolitically driven oil prices has already settled at a higher level.
That means, while oil is at its lowest point since early March, 10y EUR swap rates are still around 3%, a level that has marked a soft floor to the long end rate over the past few months. The European Central Bank has, of course, already created facts in the meantime by delivering a rate hike last week. More importantly, official commentary even after the news of the deal over the weekend continues to lean hawkish, citing first signs of second-round effects and this being no time for complacency. The market is proving very reluctant to set aside its expectations of a second ECB rate hike, which remains more than fully priced by the end of the year.
The market reaction has also been faster than realities on the ground, and it can be altered by the prospects of a deal. A more durable repricing requires safe, predictable and insured shipping through the Strait of Hormuz. And demand could likely to be higher than usual as depleted reserves need to be replenished. Re-escalation risks are reduced, but not off the table.
For longer EUR rates at least, we also think that this is also only part of the story. The US narrative of macro resilience and the hawkish repricing that went in hand with it will also have had spillover effects. After all, it has been US real rates that have driven the leg higher, all the while (market-)inflation expectations have remained at very tolerable levels. What hasn’t gone up in the first place with energy prices is unlikely to offer much relief as the latter has now come down.