The signals from oil, bonds and inflation

Ellie Henderson: The global economy has been fairly resilient despite the challenging backdrop. From a global perspective, we'd point to three key factors that have been supporting activity.

Firstly, there's clear evidence that companies have front-loaded manufacturing orders, supporting the production sector because of concerns about potential future supply-chain disruption stemming from the conflict in the Middle East.

Secondly, despite higher borrowing costs, AI investment has continued at a rapid pace. That's been supporting economies directly integrated into the AI supply chain, such as the US through its data-centre build-out and South Korea through the production of memory chips.

The last point also relates to the AI story. We wonder whether there has been a wealth effect from the AI boom and the associated rise in stock markets around the world, with consumption in many developed economies remaining largely resilient.

Callum Macpherson: The front contracts, which are prices for immediate delivery of crude oil, have increased quite sharply over the past couple of weeks as tensions have risen again.

There currently appears to be no real sign of dialogue between the US and Iran that might resolve the situation. The physical supply of oil remains tight, and the market is reflecting that in the rising front end of the curve. At the time of recording, on Monday 7 September, this is getting close to $100 per barrel.

That's now close to the August high of $102 per barrel, but still quite a bit below some of the levels we saw earlier in the war, at around $120 per barrel. Looking further forward, the average price for 2027 indicated by the forward curve is now around $80 per barrel, and that has also been increasing again.

It points to some form of disruption dragging on well into next year.

Ellie Henderson: That's a great question, and something we get asked quite a lot. Raising interest rates isn't going to open the Strait of Hormuz. It isn't going to release the trapped oil and gas in the Gulf, boost supply, and push down wholesale energy prices.

What a central bank is doing is judging whether the current spike in wholesale energy costs will lead to longer-lasting inflationary pressures over a one-to-two-year horizon. That is when policy decided now really has an effect, because there is a lag between policy changes and their impact on the real economy.

A central bank will look first at whether the price rises are contained to energy. It will be more concerned if they lead to higher wages, with households successfully negotiating higher pay to compensate for energy prices adding to the cost of living.

For you and me, higher wages are certainly a good thing. However, for a central bank targeting inflation, they could lead to a wage-price spiral and more entrenched inflation. If we see signs of that, the central bank would certainly want to act to guard against it.

Ellie Henderson: We monitor a wide range of data from both official and private sources. In the UK at the moment, there are few signs that it is spreading beyond the initial energy shock.

For example, core inflation, which excludes food, energy, alcohol, and tobacco, hasn't shifted much. Private-sector regular pay growth, which excludes bonuses and typically has the most direct link to inflation, is tracking below the pace of wage growth that the Bank of England estimates is consistent with the 2% target.

We look at those wage-growth and core-inflation numbers across economies. Policymakers will be aware that this data can turn quickly, and they will want to be nimble and flexible if it does.

Callum Macpherson: It's a combination of those things. The underlying problem is a loss of supply, or limited supply, because of the conflict. The market then has to adjust and set prices high enough for demand to come into some sort of balance with what is available, bearing in mind that inventories are finite and have been drawing down.

That equilibrium is constantly changing as views evolve about whether the conflict might end sooner or later. It is also affected by the extent to which shipping companies can get energy out of the Strait of Hormuz.

Callum Macpherson: The key things are refined products and natural gas if you want a true impression of what is going on and its implications.

There has been some success in getting oil out of the Strait of Hormuz. In particular, Saudi Arabia's east-west pipeline, which can transport around seven million barrels per day, or roughly 7% of world supply, into the Red Sea and avoid the Strait of Hormuz, has helped a lot.

But that helps with crude. For refined products such as diesel, jet fuel, and gas oil, the world market relies on refinery capacity inside the Persian Gulf. That capacity is currently inaccessible or very difficult to access.

On top of that, there is pressure stemming from the war in Ukraine because Ukraine has become increasingly effective at targeting Russian refineries. Consequently, while Brent may be coming back to $100 per barrel, diesel is heading more towards $200 per barrel.

It's a very similar story with natural gas. Before the war started, natural gas in the UK was trading at around 80 pence per therm. The price for this winter is now 180 pence per therm, more than 100% higher than when the war started.

Ellie Henderson: The rise in sovereign bond yields is something we've been monitoring quite closely, and we saw quite a rise in the first half of last week. I think it's a mixture of factors hitting at once and pushing yields higher.

Inflation is certainly one of those factors. When the conflict in the Middle East escalates, yields rise as well. However, we don't think inflation is the only thing at play. If you split yields into real and break-even yields, real yields are rising too, which suggests there is more to it.

Fiscal concerns are definitely part of it. A data point a few weeks ago showed that US national debt had exceeded US$40 trillion. These looming debt loads aren't something only the US is facing; we're seeing them across Europe and Japan as well. We think that's pushing yields higher.

We also think there is a crowding-out effect. In Economics 101, crowding out is a case of the public sector crowding out the private sector. But we wonder whether the vast amount of private AI issuance is affecting the sovereign bond market as well, weighing on prices. Prices move inversely to yields, so this pushes yields higher.

Ellie Henderson: It's safe to say I don't envy any central banker right now. Central banks around the world face threats to their credibility because inflation has been above target for so long. In the UK and the US, it has been around five years. Policymakers are also trying to navigate a world where external shocks are coming from all angles and preventing inflation from returning to target.

Of the central banks you mentioned, the Federal Reserve probably faces the most difficult decision, particularly at its upcoming meeting. It is trying to navigate all of this while protecting its independence, which is another challenge. Last week, President Trump once again said he wanted lower interest rates, which is not necessarily right for the situation.

The Fed's decision is difficult because of both the macro fundamentals and other external pressures.

Callum Macpherson: It's a very difficult call for consumers at the moment. Consider an airline deciding when to hedge for the summer of 2027. It would currently have to do that at a much higher price than it did last year. But it also knows that, if something changed in the conflict, the market could very quickly become oversupplied and prices could fall quite dramatically. That could happen if the Iranians and Americans came to an agreement, or if one side simply threw in the towel.

We know inventories will need to be rebuilt, but prices could nevertheless fall dramatically, so somebody hedging now faces that risk. Of course, if they don't hedge, there is another risk. So far, consumers have tended to hold on and avoid hedging, but the price has risen and delaying that decision has been expensive.

History suggests that the only thing you can do when you really don't know what the future holds is to keep going, hedging a little at a time to average the rate.

Ellie Henderson: The risk backdrop right now isn't exactly supportive of high levels of investment. Take the Middle East conflict: it's not at all clear how it will develop.

As Callum said, things can change very quickly. It's certainly plausible that there have been many back-channel conversations and negotiations that we're not aware of, and that a resolution could arise tomorrow, pushing borrowing costs lower. On the other hand, the conflict could escalate again, pushing borrowing costs higher.

That makes it very hard for companies to plan big investments because they don't know where borrowing costs could be or what macro backdrop they will face. In the UK, there is also uncertainty ahead of Chancellor Healey's first Budget on 28 October, which could bring big changes to fiscal policy.

It's a hard backdrop for companies.

Ellie Henderson: It's certainly the evolution of the conflict in the Middle East. Our base case assumes a swift resolution that allows the Strait of Hormuz to open and oil and gas to leave the Gulf.

However, it's also very plausible that the conflict will last much longer than we assumed. At the start, we thought it would last weeks; we're now at the six-month stage. But both sides have an incentive to reach a resolution. In the US, midterm elections are around the corner, and Iran is feeling a great degree of economic pain from the sanctions.

Callum Macpherson: I would look at the premiums of products such as diesel over Brent. At the moment, Brent is trading close to $100 per barrel, while diesel is trading $100 per barrel above that, at $200 per barrel. These spreads are very unusually wide. A spread of around $15 to $20 per barrel would be much more usual.

When that starts to come down at the short end of the curve and further out into 2027, we'll start to believe that the market is looking in better shape.

Ellie Henderson: For us, I don't think it will be a traditional economic data release such as inflation, a particular market move, an interest-rate decision, or a commodity. It will probably be Truth Social posts. All our forecasts come back to the evolution of the Middle East conflict, as we discussed, and President Trump communicates through Truth Social.

I think we'll be refreshing that constantly over the coming weeks and months, as we have been.

Callum Macpherson: For me, it's the flow of physical energy, whether oil, gas, or refined products. Ultimately, the market is driven by how much energy can flow, and that's the key thing.

Whatever President Trump or the Iranians say, President Trump can say that the Strait of Hormuz is open, but if no ships are passing through it, then as far as the energy market is concerned, it's closed. It's the energy flows that count.

Jeremy Max: Ellie Henderson and Callum Macpherson, thank you for joining me on this special podcast for Investec UK.