Currently, the US stock market continues to reach new highs, while oil prices and market expectations for interest rates remain at high levels; it's difficult for these two factors to coexist. This article analyzes potential biases investors may exhibit in their judgments regarding central bank policies.



A striking recent market phenomenon is that while the stock market has fully priced in the impact of geopolitical conflicts and repeatedly hit new highs, oil prices and consequently, central bank interest rate expectations, remain significantly higher than pre-conflict levels. It's difficult to believe that either accurately reflects reality. Four noteworthy discrepancies exist in market expectations regarding central bank policies.

First, the probability of the Federal Reserve raising interest rates is overestimated.

After earlier expectations of interest rate cuts subsided, the market now perceives a slightly higher probability of a Fed rate hike than a cut. The gap between US and Eurozone interest rate expectations has widened, with the repricing magnitude since the outbreak of the conflict being roughly the same in both economies. This shift is primarily due to weaker-than-expected Eurozone economic data, while the US economy has performed relatively robustly. Simultaneously, the rebound in US stocks has weakened the case for a recent rate cut, and Fed officials have actively guided the market to raise interest rate expectations.

However, the likelihood of a Federal Reserve rate cut before the end of the year remains high. The core disagreement lies in the assessment of the US job market. Fed officials emphasize that the sharp decline in net immigration coupled with an aging population means that labor supply growth has nearly stagnated. This implies that even zero or slight negative employment data may not necessarily be a strong alarm. On the other hand, overall US labor demand is weak, and the job market's resilience is lower than it was three or four years ago. Fewer job vacancies are more likely to push up the unemployment rate, and new job creation is highly dependent on a few sectors such as healthcare and social services. Therefore, the vulnerability of the job market cannot be ignored.

Second, the expected repricing magnitude of UK interest rates is too large.

Compared to pre-conflict levels, the market currently expects UK interest rates to be more than 1 percentage point higher a year from now, significantly exceeding the European Central Bank's repricing margin. This partly reflects the UK's experience of facing more persistent inflationary pressures in 2022. However, this assessment is only half correct. While the UK is indeed highly dependent on natural gas, there is no gas crisis currently, and gas prices are far more stable than in 2022. In terms of net energy imports, the UK outperforms most European countries. Overall, UK inflation forecasts are largely consistent with those of the Eurozone.

Third, the probability of the Bank of England raising interest rates is lower than that of the European Central Bank.

While markets have priced in similar tightening levels for the remainder of the year in both the UK and the Eurozone, the European Central Bank (ECB) is more likely to raise interest rates. The two central banks conveyed significantly different messages last week: the ECB explicitly stated it would raise rates in June if the situation remained unchanged; while the Bank of England hinted that maintaining current rates already constituted a de facto tightening, and the necessity for further rate hikes was unclear. We anticipate a rate hike on both sides of the English Channel, but the overall tightening力度 (intensity/strength) may be greater with the ECB.

Fourth, the market is overly focused on oil prices rather than natural gas prices.

Market expectations for interest rates from the European Central Bank and the Bank of England remain highly correlated with oil prices. Since the conflict, the correlation coefficient between the two-year euro swap rate and Brent crude oil has been as high as 0.83, while its correlation with natural gas is only 0.22. The core issue for European inflation in 2022 is natural gas and electricity prices, not crude oil. Central banks may be less sensitive to oil prices in the future than current market pricing. As long as natural gas prices remain low, the necessity for significant interest rate hikes by central banks will decrease significantly.

Market Focus Next Week

Next week, the US will release its April inflation data. Driven by rising gasoline and diesel prices, core inflation is likely to rise for the second consecutive month by 0.9%, and may even rebound. However, we believe this increase is more of a temporary phenomenon, lacking a broad and sustained demand-driven inflationary foundation. Retail sales and industrial production data will also be released. In addition, Powell will end his term as Federal Reserve Chairman.

Overall, current market expectations for central bank tightening may be too high, especially given the stable natural gas prices. The central bank's policy stance may be more moderate than currently priced in by the market. Investors need to closely monitor the latest developments in employment, inflation, and energy prices.