We've now seen a couple of episodes of official jawboning to calm markets. Scott Bessent came in last week, to publicly address key market fears, markets calmed. This week, a coordinated effort to talk UP oil supply did the trick.
Both addressed sentiment shocks. But let's take a look where the pain is proving to be fundamentally structural, not just a shock to sentiment.
We can see it in this chart …
This shows the change in central bank policy outlook (the Fed in blue and the European Central Bank in red) since the U.S. strikes on Iran.
As you can see, the market outlook for the policy rate by the end of the year has gone up (relative to pre-war levels) for both, over the past 8 trading days.
But the market expects the Fed to cut rates more than a quarter point by year end.
In Europe the pendulum has swung from easing to tightening. The market is now looking for more than one quarter point hike from the ECB.
So, the two most powerful central banks in the world now have a 64 basis point divergence in rate expectations by year end — and it's widening.
Why the U.S./Europe divergence?
The U.S. is energy dominant (a net exporter). Europe is energy dependent.
As we observed in this chart on Monday, due to the U.S./Iran war, Europe is now paying the equivalent of six times more than the U.S. for energy (nat gas).
This puts pressure on European fiscally fragile countries, especially those with high energy spending relative to the size of their economies (energy/GDP). Italy fits the description for both.
So the behavior in the interest rate markets (from our first chart) is about fiscal risk, not about inflation.
This is why the Italian bond yields are moving higher, faster than more fiscally sound parts of Europe. This is why the euro is down almost 2.5% against the dollar since the war. And it's why were European stocks are feeling more pain than U.S. stocks.
