BNY’s Americas Macro Strategist John Velis argues that the Middle East conflict hits the U.S. economy via higher Oil prices, weaker portfolios and greater uncertainty, creating a negative supply shock. Markets have scaled back expectations from just over two to well under two Fed cuts this year, while Velis still anticipates three cuts as labor market weakness becomes more evident.

Negative supply shock and labor risks

“The U.S. economy – and ultimately rates – are affected by the Middle East conflict through three channels.”

“Higher oil prices risk inflation and have raised yields through the expectations channel, as we have noted.”

“Financial market instability affects consumer portfolios, which through the wealth effect could depress consumer demand (as can the real income effects of higher oil prices). Asset volatility can also affect financial planning and postpone investment or hiring activities.

“The third channel, related to the first two, is a broad increase in economic uncertainty that depresses consumer and business behavior. The growth and inflation effects of the conflict come from the negative supply shock it creates, driving the aggregate supply curve in and to the left, raising prices and restraining output.”

“Before the outbreak of hostilities, the market had discounted just over two rate cuts by the end of the year.”

“Since then, something well short of two cuts is priced in, reflecting less dovish expectations for the central bank.”

“This sets up a dilemma for the Fed, which was already confronting sticky inflation and waning labor demand before the conflict began.”

“This is why we have been expecting three cuts this year from the Fed.”

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