Central banks caught in a dilemma: The oil shock keeps inflation elevated

• Jan Felix Gloeckner
  Senior Investment Specialist
  Insight Investment

The backdrop is reinforced by strength in corporate earnings and underlying company fundamentals, as was evident during the latest reporting season. However, the balance of risks is still uneven in our view. It suggests some moderation ahead. Inflation remains above target and is rising in some areas. The data continue to show a clearer transmission from energy and geopolitical pressures, and the near-term outlook suggests this pressure is likely to persist while the oil shock remains in place. The effect is expected to be most acute in Europe and Asia, where larger energy importers appear more exposed to further cost pressures. This is reflected in rising input and output costs, alongside longer supplier delivery times. Under both the base and alternative cases, inflation remains in an above-target and rising regime, with energy effects continuing to feed through in the near term. 

US

Our central case remains that GDP growth will be close to 2% both this year and in 2027, underpinned by the ongoing surge in digital and AI infrastructure development. Although the inflation cycle appears likely to turn before long, if the agreement between the US and Iran holds, we believe the inflation rate will remain above target for some time, being 3.4% in 2026 and decelerating to 2.5% next year. Any renewed flare up in hostilities increases risks to both growth and inflation. Through the outlook is still uncertain, we expect the Fed will leave rates unchanged while policymakers assess the impact of the energy price shock on employment and inflation. A prolonged shock would raise near-term inflation risks while increasing the risk of weaker growth. Currently, we do not expect the Fed to respond by raising short-term rates, despite market pricing. Countering that view, near-term price pressures are likely to delay potential Fed cuts, while second-round effects could weigh on consumption and the labour market. The duration of the oil supply shock is likely to be the critical deciding factor. We believe monetary policy to be poorly suited to combatting stagflation, but strong global incentives to ease energy prices support the case for eventual resolution to the war. We believe 10-year Treasury yields are likely to be close to current levels in a year’s time, around 4.40%. Yields at shorter maturities are expected to ease below 4% over time. 

Eurozone

Prior to the war in the Middle East, leading indicators for the eurozone had been reasonably resilient. The recovery was being led by Spain. German and French growth was anaemic, while Italy’s was slowing as tailwinds faded. The manufacturing sector that has been under pressure for some time is showing signs of recovery. We believe positive real wage growth in 2026 could support consumption, but savings rates remain elevated. Consumer confidence remains low as a consequence of the conflict and added to consumer expectations for inflation. However, the labour market appears to be resilient and the prospect of additional support coming from Germany’s expanded fiscal spending had added upside risks to the admittedly modest growth forecasts. We see GDP expanding by about 0.5% in 2026 with an improvement to 1% in 2027. Meanwhile, the headline level of inflation is expected to remain above the 2% ECB target level, 2.7% for 2026 before easing back to almost 2.3% over the next year. Having increased rates once already, we expect the ECB is likely to hike once more before allowing a pause as inflation begins to moderate, before easing policy gradually back toward 2%. We see 10-year German government bond yields just below current levels this time next year around 2.9%, with the curve steepening to some degree as shorter-dated yields fall back as inflation pressures reduce.

Investment grade credit 

Spreads tightened sharply in the second quarter, supported by strong earnings momentum and hopes of conflict de-escalation. This move returned valuations close to the tightest levels since the global financial crisis. However, elevated all-in yields continued to draw investor demand despite heavy primary supply. This issuance has been led by hyperscaler tech companies, whose capex financing needs remain relentless. They are accessing global markets at pace across a range of different currencies. If this trend persists, then the tech sector’s weight in major bond indices will rise materially, albeit from a low base. Robust investor appetite means we are tactically positive on US and euro markets, supported by high absolute level of yields. Strong tech supply is exerting pressure on spreads within that sector, with AA-rated issuers now trading in line with A-rated credits in other sectors, reflecting ongoing supply overhang. Where mandates allow, we see an opportunity to add selectively at these levels. In this environment, dispersion is rising, reinforcing the importance of disciplined active management, careful security selection, and a focus on relative value. 

High yield credit 

Despite a volatile global backdrop, high yield markets have shown notable resilience, with steady income continuing to underpin returns. Encouragingly, many issuers remain disciplined, actively deleveraging and managing balance sheets in contrast to rising leverage at the sovereign level. However, the market is becoming increasingly differentiated, with rising levels of dispersion among issuers. Artificial intelligence (AI) is a key catalyst for this, driving new supply to fund the infrastructure build-out, while also disrupting existing business models, especially in the software sector. Although there are positive signs that the conflict in the Middle East may be on a de-escalating path, the outlook remains uncertain. This leaves us with a bias towards US issuance, given that the US has a stronger growth outlook and is more insulated from higher energy prices. Defaults remain low by historical standards, and we see little reason for material deterioration, given the improving quality of public high yield debt issuers and the continued migration of weaker credits towards private markets. We see promising opportunities to add exposure in telecommunications, healthcare and other industries that are likely to be less affected should the conflict flare up once again.

Currencies

Currency markets are likely to be driven by resilient global growth, elevated energy prices and widening differences in fiscal and external positions. The US dollar is likely to remain supported in the near term by stronger US growth, energy-driven inflation and a repricing of Federal Reserve expectations. As an energy exporter, the US also benefits from the current backdrop, although fiscal deficits and policy uncertainty remain longer-term headwinds. The euro faces pressure from higher energy costs and weaker terms of trade, though increased defence spending could support growth over time. Sterling remains exposed to energy shocks, which may create volatility. Japan’s energy import dependence and deteriorating terms of trade continue to weigh on the yen, with intervention unlikely to offset weak fundamentals. The Australian dollar is supported by a resilient economy but remains vulnerable to changing rate expectations, while the New Zealand dollar is benefiting from improving growth prospects. The Canadian dollar remains unfavoured in the dollar bloc amid labour market concerns, trade uncertainty and lower energy prices. The Norwegian krone continues to benefit from higher oil prices and a relatively hawkish central bank, while the Swedish krona is supported by improving growth and attractive valuations. The Swiss franc is expected to remain underpinned by safe-haven demand. Overall, energy exposure, fiscal fundamentals and external balances are likely to be key drivers of currency performance.