Introduction

A lot has unfolded over the past five years. We’ve experienced three major supply shocks that have reverberated through the global economy. First was COVID, a massive supply shock, followed by tariffs, and now rising geopolitical risk highlighted by disruptions in the Strait of Hormuz.

Markets have been whipsawed in recent months. We moved from pricing in rate cuts, to a bond rally driven by expectations of AI-led disinflation and a productivity boom, and now to a sell-off as inflation risk premia rise.

The broader macro backdrop remains highly uncertain. The purpose of this analysis is to break down what we are currently seeing across macro, rates, FX, and credit markets.

Macro

The econometric transmission model illustrates the macroeconomic channel through which disruptions to transit volumes through the Strait of Hormuz propagate through the global economy. The model treats declines in transit volumes as a negative supply shock, which first affects global supply chain conditions and subsequently feeds through into inflation.

The results show that a negative transit shock produces the largest deterioration in global supply chain elasticity approximately 4–5 months after the disruption. At this point the supply chain response reaches its most negative level, reflecting tightening logistics capacity, reduced shipping availability, and increased input frictions. In practical terms, this indicates that a disruption to oil flows and maritime trade does not fully transmit immediately; instead, the impact builds as inventories deplete, shipping routes adjust, and energy costs begin to feed through production networks.

Inflation responds with a positive impulse following the supply-chain deterioration, with the peak CPI response occurring earlier in the transmission window but remaining elevated as supply conditions worsen. The relationship therefore appears asymmetric and sequential: the deterioration in supply chain conditions precedes and amplifies the rise in inflation. As the supply chain elasticity becomes more negative indicating greater rigidity and reduced flexibility in global trade networks the inflationary impulse strengthens.

This pattern is consistent with the economic intuition of energy-driven supply shocks. A disruption in the Strait of Hormuz reduces the effective flow of energy and goods through a critical global trade artery. The immediate effect is logistical strain in global shipping and production networks, which manifests as declining supply chain elasticity. As these frictions accumulate, firms face higher transportation costs, longer delivery times, and tighter inventories. These constraints ultimately translate into higher producer costs and rising consumer prices, producing the observed inflation response.

A sustained increase in oil prices transmits to real economic activity with a lagged effect. The pass-through operates sequentially through higher headline inflation, a compression in real disposable income, a subsequent slowdown in consumption, and ultimately a drag on aggregate output. Consistent with this transmission mechanism, impulse response functions (IRFs) typically exhibit a delayed trough in GDP rather than an immediate contraction on impact.

Under current market-implied conditions and historical elasticities, the cumulative impact on real GDP is estimated to be approximately 45 basis points at peak effect.

A one standard deviation uncertainty shock induces a persistent decline in real GDP. The contraction intensifies over the first 6–7 months, reaching a trough of approximately -25 basis points, before gradually dissipating. However, output remains below baseline even after 18 months.

These results underscore that uncertainty shocks exert economically meaningful short-run effects on aggregate activity.

In the baseline scenario, headline CPI is projected to peak at approximately 3.0% in mid-2026 before gradually moderating to around 2.7% by year-end. Under a temporary oil price shock, CPI rises more sharply, reaching roughly 3.4% in the near term, but subsequently declines as energy base effects reverse and pass-through effects dissipate. In contrast, a persistent oil price shock leads to a more sustained inflationary profile, with CPI increasing to approximately 3.5% in mid-2026 and remaining elevated, ending the year near 3.0%, reflecting more durable second-round effects.

Energy price shocks are typically associated with front-loaded increases in inflation due to the relatively rapid pass-through of energy prices into headline CPI. The persistence of this inflationary impulse depends critically on underlying supply-demand dynamics, including the duration of the shock, the speed of inventory adjustment, and the extent to which second-round effects propagate into wages and core inflation.

A disruption or closure of the Strait of Hormuz would constitute a negative supply shock, shifting the short-run aggregate supply (SRAS) curve leftward. In the near term, aggregate demand is likely to remain relatively inelastic, particularly given contractual rigidities, inventory buffers, and limited immediate substitution away from energy inputs. Under conditions of low short-run price elasticity of supply, the adjustment mechanism occurs primarily through higher prices rather than increased output.

This dynamic raises the probability of a supply-driven recession characterized by stagflationary pressures simultaneously weaker real activity and elevated inflation. The risk is particularly acute for energy-importing economies, especially in Asia, where higher import dependence and limited short-term substitution amplify the transmission of energy price shocks into both inflation and real income compression.

The chart illustrates the dynamic response of inflation across major Asian economies following a common energy supply shock, scaled by import exposure to the Strait of Hormuz. Using a country fixed-effects framework with import-weight interactions, the results highlight both the magnitude and timing of pass-through.

Three key patterns emerge.

First, inflation responses are highly heterogeneous. Economies with greater exposure to energy imports most notably China experience significantly larger price pressures, with peak CPI responses approaching 90 basis points. In contrast, lower-exposure economies exhibit more muted effects, underscoring the importance of trade structure in shaping inflation outcomes.

Second, the pass-through is delayed and persistent. Inflation builds gradually, peaking around four to six months after the initial shock, reflecting transmission through production chains, inventory cycles, and retail pricing adjustments. The subsequent decline is slow, indicating that supply-driven shocks can have prolonged effects on price levels.

Third, at the regional level, the aggregate response remains economically meaningful, with inflation rising by roughly 50–60 basis points at peak. This suggests that even localized disruptions to key energy transit routes can generate broad-based inflationary pressures across integrated economies.

Overall, the evidence points to a transmission mechanism in which external supply shocks propagate through trade linkages, with highly exposed economies acting as amplifiers of global inflation dynamics.

The chart combines global inflation, growth, and an elasticity-based measure of demand versus supply responsiveness to assess how macro regimes evolve following supply disruptions. The elasticity spread defined as demand elasticity minus supply elasticity is smoothed over a longer horizon to capture structural shifts rather than short-term fluctuations.

Several patterns emerge.

First, elasticity provides a useful lens for distinguishing the drivers of inflation. Periods in which elasticity is positive are typically associated with demand-driven expansions, where strong growth coincides with rising inflation. In contrast, a decline in elasticity particularly into negative territory signals that supply conditions are becoming more constrained or less responsive, altering the nature of inflation dynamics.

Second, the historical relationship shows that negative elasticity is often associated with weaker growth outcomes, but its inflation implications depend on the source of the shock. When driven by supply constraints rather than demand weakness, falling elasticity tends to coincide with persistent or rising inflation, reflecting cost-push pressures.

Third, the forward-looking scenario, based on the recent decline in energy transit volumes, suggests a shift toward a more inelastic supply environment. Under this configuration, elasticity moves lower, global growth softens, and inflation remains elevated. The projected path is consistent with a supply-constrained slowdown, rather than a typical demand-driven cycle.

Taken together, the evidence indicates that disruptions to global supply proxied here by reduced transit volumes—can simultaneously weaken growth and sustain inflation, highlighting the importance of elasticity-based measures in identifying emerging stagflationary risks.

The economy has reached a level of utilization consistent with the effective demand limit given current utilization, and is now transitioning into a phase where further expansion is constrained, leading to what should be some softening in output.

The economy currently appears to be in an “overheating” regime based on income and inflation dynamics, household behavior is not consistent with demand acceleration.

Instead, elevated inflation expectations are suppressing the marginal propensity to consume, suggesting a more cautious consumer and a weaker than expected demand and pulse going forward. Consistent with what is found in effective demand.

The surface shows how output evolves relative to its effective demand constraint over time. Rather than being fixed, this constraint shifts gradually with underlying structural forces, while tightening as effective demand rises. In other words, stronger demand does not expand capacity indefinitely, it compresses the room for further growth.

The cycle moves along this surface. During expansions, the economy rises toward the boundary and the distance to the constraint narrows. Once near that limit, additional demand produces diminishing gains in output and the system begins to adjust.

Right now, the economy sits very close to that boundary with a slight overshoot. This suggests the system is operating at its effective demand limit, where further expansion becomes difficult and the balance of risks shifts toward a cooling in activity rather than continued growth.

This chart reframes the cycle through distance to the effective demand ceiling rather than the level of output itself. The surface represents the evolving constraint, while the colored observations show how far the economy sits from that limit at each point in time.

Across cycles, the pattern is consistent. The economy moves from periods of slack, where distance to the ceiling is positive, toward phases where that distance compresses. As it approaches zero, the system becomes constrained and further expansion loses traction.

Currently, observations cluster near the boundary, with distance to the ceiling close to zero. This indicates the economy is operating at its effective demand limit. In this regime, the likelihood of continued expansion is low, and the adjustment process typically involves a move back below the constraint rather than a sustained push above it.

As it relates to the Fed right now looking at Fed Speak the main driver is inflation being prioritized over labor.

Credit

Dubai real estate bonds have come under increasing pressure amid heightened geopolitical tensions in the region. Six dollar-denominated sukuk issued by property firms are currently trading at distressed levels, defined as yield spreads exceeding 1,000 basis points above the risk-free rate, based on data compiled from Bloomberg.

These securities account for roughly 15% of dollar-denominated real estate bonds in the Middle East.

At present, Binghatti 2027 is the most distressed issue, followed by Binghatti 2029.

GCC credit spreads have also widened since the onset of the war.

We have seen further rising as sovereigns no longer able to anchor spreads.

Geopolitical risk affects Gulf sovereign credit markets primarily during crisis periods.

When spreads are already elevated, geopolitical shocks:

1. Increase perceived sovereign risk

2. Widen CDS spreads further
amplify stress in credit markets

But during calm periods, markets largely ignore GPR shocks.

GPR rising with worries already implied in CDS should further increase perceived sovereign risk.

QQA shows geopolitical risk impacts Gulf CDS (Bahrain + Saudi+Kuwait+UAE+Qatar) only in stress regimes: little effect in normal times, but strong, positive effects when both GPR and spreads are high. Risk transmission is nonlinear, asymmetric, and tail-driven.

Markets are behaving exactly as you’d expect in the early phase of a geopolitical shock high-frequency, information-driven volatility with sharp swings in both directions. The key signal isn’t just equities or rates, but credit.

The rise in 5Y high-yield CDS in the Middle East reflects a surge in demand for protection, not just deteriorating fundamentals. In other words, investors are actively pricing tail risk. When uncertainty spikes, CDS becomes the cleanest hedge, so spreads widen even before actual defaults or balance sheet stress materialize.

This fits with what we’re seeing across markets:

• Equities weakening globally

• Credit spreads widening modestly

• USD firming as a relative safe haven

• Rates drifting lower on growth concerns

If the conflict remains contained, this is likely a temporary repricing of risk more about positioning than solvency. Issuance pauses, liquidity thins, but markets normalize quickly.

If it drags on, CDS becomes the leading indicator. Sustained widening would signal a shift from hedging demand to genuine credit deterioration, tightening financial conditions and reinforcing the growth drag.

For now, this is a risk transfer event not yet a credit event.

From a geopolitical standpoint, attacks on infrastructure appear to be putting upward pressure on credit risk. Credit risk has been rising for banks in Asia, while, since the initial onset, credit risk for EU- and US-domiciled banks has improved and remained relatively stable. Middle Eastern exposures within Asian bank portfolios could begin to see rising defaults and a slowdown in lending across the region.

Transportation is experiencing significant disruption as Strait of Hormuz volumes have declined sharply. Insurance costs have risen substantially, with some insurers withdrawing coverage altogether. Global trade volumes are currently contracting, while energy costs continue to increase, putting pressure on both the shipping and airfreight sectors. More recently, there have been signs of recovery amid ongoing negotiations and the potential easing of both energy and insurance costs.

Outside of the Middle East we are seeing some vulnerability specifically in Europe. Europe is an energy importer relying on both oil and natural gas for consumption and industrial production. United States is an oil and gas producer and is much more insulated from rising prices compared to Europe. With the rise in energy prices EUR credit could underperform USD credit.

Rates

Markets have raised forward policy expectations throughout the conflict, with even longer-term policy expectations repricing higher.

The rise in market-implied inflation expectations (2y inflation swaps) has been a key driver of the repricing in 1y1y SOFR. Against a backdrop of elevated geopolitical risk and a wide dispersion of potential outcomes, markets are likely to oscillate in their assessment of the inflation impulse. That uncertainty will continue to feed directly into policy expectations assuming labor market conditions remain broadly resilient.

More hawkish Fed has also helped to price out right cuts and lead towards the probability of hikes going in 2027 1H of 2027.

Rising fiscal pressures, particularly from sustained geopolitical conflict and defense spending, could push deficits higher. Historically, worsening fiscal balances have been associated with tighter long-end swap spreads. Current market pricing implies a very large deterioration in fiscal conditions, though potential policy measures could partially offset the impact.

The repricing is no longer confined to the front-end. The upward shift in the long end suggests markets are embedding a more persistent inflation premium across the Gulf, rather than treating this as a purely transitory shock.

Reverse-NOK issuance continues to dominate, supported by still-depressed basis levels and typical seasonal supply patterns early in the year. Policy divergence is beginning to emerge, with Norges Bank leaning more dovish relative to the ECB, though sticky inflation may delay easing and provide some near-term support. However, Norwegian bonds remain less attractive on a hedged basis versus core European alternatives, limiting inflows and reducing support for further basis tightening.

Issuance dynamics point toward further tightening in EURSEK cross-currency basis. Strong reverse-SEK issuance has already driven widening, but improving domestic growth, rising sentiment, and fiscal support create conditions for tighter policy expectations. SEK-denominated assets are becoming more attractive on a hedged basis, which could reinforce tightening. The main downside risk comes from geopolitical shocks, which could temporarily reverse this trend via risk-off flows.

The case for steepening in the EURUSD cross-currency curve remains intact, driven primarily by expected divergence between EUR and USD rates. The view is that EUR rates will lag USD, while the EUR curve steepens more aggressively. Swap spread dynamics reinforce this, with USD spreads supported by structural factors such as deregulation, while EUR spreads face tightening pressure from increased sovereign issuance, particularly out of Germany.

The main challenge to the trade is carry; negative carry makes positioning more difficult in a low-volatility environment where carry-focused strategies dominate

A 2y-5y steepener (Brazil) expresses the view that near-term policy remains constrained by inflation shocks, while the medium-term path reflects the onset of an easing cycle, leading to a steeper curve.

FX

Not all oil shocks move FX the same way. EM FX beta to oil demand vs. oil supply shocks. BRL, MXN: benefit from demand-driven oil rallies. ZAR, HUF: more sensitive to supply disruptions. CNY, MYR, PHP: typical oil importers oil up = FX pressure. CZK benefits from both (rare)

Still expecting a weaker JPY, despite today’s bid. The erosion in the trade balance should continue to weigh on the currency.

Japan’s external adjustment is increasingly price-driven rather than volume-driven.

As import supply becomes more inelastic, higher global prices widen the goods deficit instead of compressing demand.

The result: the current account, goods balance, and trade balance are down roughly 80% month-over-month.

That erosion matters for FX.

A weaker JPY no longer improves the balance; instead, it raises the import bill, sustaining FX outflows.

With the current account losing its stabilizing role, fundamentals point to continued depreciation pressure on the JPY unless prices fall or supply elasticity improves.

The widening in USD/SAR forwards is less a reflection of deteriorating fundamentals and more a function of convexity pricing under geopolitical uncertainty. With the peg representing a low-volatility regime, any increase in tail risk leads to a disproportionate rise in hedging demand. As a result, forwards embed a risk premium for nonlinear outcomes, even as spot remains anchored and oil prices remain elevated.

TRY’s headline yield remains elevated, but the compression in carry-to-vol suggests that FX volatility is increasingly offsetting the carry. In a regime of managed depreciation, the trade depends on a smooth adjustment path. As volatility rises relative to yield, the risk of nonlinear FX moves increases, reducing the effectiveness of carry and making returns more fragile. Given this, think carry looks attractive elsewhere.

The BRL had been a strong performer against the USD since the beginning of the year, but this trend may be reversing. The Central Bank of Brazil may need to raise rates in response to rising inflation expectations. The purple line shows the 1-year forward implied policy rate differential between the BCB and the Federal Reserve.

We are now seeing that spread widen as short-term inflation shocks (red line, representing 1-year inflation swaps) have increased significantly. This suggests growing pressure on policy tightening, which could ultimately weigh on the BRL and lead to depreciation against the USD.

Overall, Egypt has seen some improvement in its balance of payments, with exports rising modestly and imports declining slightly. At a fundamental level, exchange rates are largely influenced by a country’s trade dynamics exports should ideally finance imports. When this balance is not maintained, foreign suppliers may scale back exports, forcing the country to limit imports to what is essential or affordable. Over time, excessive reliance on imports can place downward pressure on the currency.

The core issue for Egypt is its structural dependence on food imports. Looking ahead, external shocks in the Middle East are likely to put renewed pressure on the balance of payments. This helps explain the recent weakness in the Egyptian pound (EGP) observed over the past few days.

What drives FX leadership is not static carry or relative growth in isolation, but the interaction between terms-of-trade shocks and the global growth impulse.

The top panel shows the cumulative performance of a commodity-exporter basket relative to importers. The signal is persistent. Exporters outperform when the global backdrop supports both pricing power (oil) and demand (growth revisions).

The second panel reframes this through a macro state space. Each point represents a monthly environment defined by oil momentum and global growth revisions, with color capturing FX leadership.

A few things stand out:

When both oil momentum and growth revisions are positive, outcomes cluster in the upper-right quadrant and are consistently associated with exporter outperformance. This is the classic reflation regime, where terms-of-trade improve and capital rotates into commodity-linked FX.

In contrast, when growth deteriorates despite firm oil prices, dispersion increases. This is more consistent with stagflationary conditions, where exporters do not uniformly benefit because demand destruction offsets pricing gains.

When both oil and growth weaken, importer FX tends to outperform. This reflects a disinflationary impulse, where lower commodity prices ease external balances for importers while compressing exporter revenues.

The key takeaway is that FX rotation is fundamentally a joint function, not a univariate story. Oil alone is insufficient. Growth alone is insufficient. It is their interaction that determines leadership.

With the overall outlook being potentially for oil up, world growth down, and potential for US growth to be up (relative to world) the overage cumulative return for exporters from a FX perspective is around 7.5%.

One that I wanted to isolate is USD/NOK which has seen a huge improvement in their terms of trade, essentially allowing for an isolation from the shock faced by the rest of Europe and Asia. This should help to boost real incomes, and support consumption domestically, while potentially lifting growth, and allowing for a somewhat relative cap on inflation.

Conclusion

Taken together, the current environment is best understood as a transition toward a more supply-constrained global regime, where the interaction between energy shocks, geopolitical risk, and slowing demand is driving cross-asset behavior.

The macro evidence points to a system operating near its effective demand limit, where additional shocks no longer translate into higher output, but instead into higher prices and tighter financial conditions. This is consistent with the observed shift toward a more inelastic supply backdrop, where disruptions to key trade arteries such as the Strait of Hormuz propagate through supply chains with lagged but persistent effects on inflation and growth.

Markets are increasingly reflecting this shift. Rates are repricing higher across the curve as inflation risk premia rebuild, credit markets are beginning to price tail risk rather than fundamentals, and FX is rotating along terms-of-trade dynamics rather than traditional carry or growth differentials.

Within this framework, FX leadership becomes a function of relative exposure to the shock. Commodity exporters benefit when pricing power remains intact, but that advantage becomes less stable when growth deteriorates and demand destruction offsets the gains from higher energy prices. Importers, particularly those with high external energy dependence, remain vulnerable to both inflation and balance-of-payments pressure.

The key implication is that this is not a typical cyclical slowdown. It is a nonlinear adjustment process, where supply-side constraints dominate and traditional relationships weaken. In this regime, dispersion across regions and asset classes increases, and positioning becomes more sensitive to the joint path of energy prices and growth rather than either in isolation.

Looking ahead, if oil remains elevated while global growth continues to soften, the environment increasingly resembles a stagflationary configuration, where volatility persists, policy trade-offs intensify, and cross-asset rotation remains the defining feature of markets.