Shenwan Macro Zhao Wei: No Rate Cuts May Be the Fed's "Bottom Line"

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Source | Zhao Wehong Macro Exploration

Text | Zhao Wei, Chen Dafei, Zhao Yu, Wang Maoyu, Li Xinyue

Summary

Since the Middle Eastern geopolitical conflict at the end of February, crude oil prices have continued to rise, sparking concerns about stagflation. The March FOMC meeting adopted a hawkish stance, triggering tightening trades, and the market began to speculate on whether the Federal Reserve will raise interest rates this year. The Fed’s hawkish policy stance aligns with expectations, but “no rate cuts” remains the “bottom line,” with ongoing attention on the negative feedback from tightening financial conditions.

(1) The market is betting on a 2026 rate hike by the Fed, but it remains a “low-probability event” for now

The “long-termization” of Middle Eastern conflicts and the sustained rise in oil prices are increasing the risk of stagflation and liquidity tightening. After the March FOMC meeting, US financial stress significantly increased, and the market began to speculate on the possibility of the Fed raising rates again. As of March 20, the probability of a 25bp rate hike in 2026 has risen from 0% a month ago to 12%.

We believe that not cutting rates or maintaining a hawkish stance in 2026 is the “bottom line”—a rate hike is an extremely low-probability event. This is mainly based on: first, the conditions for a “great stagflation” similar to the 1970s are not sufficiently met; second, short-term inflation pressures will be suppressed through mechanisms such as real income effects, financial conditions, wealth effects, and expectations, creating a “self-reinforcing” effect on oil prices and inflation.

(2) Supply shocks to crude oil are unlikely to cause “great stagflation” again, but oil price peaks or the resumption of rate cuts are preconditions for easing

Firstly, the US does not have the conditions to produce “great stagflation.” If Middle Eastern conflicts escalate to extreme scenarios, the US economy is more likely to experience recession after a brief stagflation. The core mechanism of stagflation is the “wage-price spiral”—the profit-price spiral is fragile because inflation caused by supply shocks is sustainable only if wages follow inflation. The “great stagflation” of the 1970s fits this mechanism, but today’s US does not meet these conditions: 1) medium- and long-term inflation expectations remain anchored; 2) collective bargaining power of unions is lacking; 3) the Federal Reserve is more independent. The 2022 Russia-Ukraine conflict was an extreme stress test. With oil prices reaching an average of $123/barrel, delayed Fed rate hikes, active fiscal policies, ample excess savings, and a tight labor market, the spillover effects of oil price increases were controllable—the CPI peak and oil price peak both occurred in June 2022, with core CPI peaking in September.

Faced with inflation pressures from supply shocks, the Fed’s policy leans toward focusing on short-term inflation, prioritizing “keeping steady” and adjusting as needed. Geopolitical conflicts since WWII are short-term in nature, and their impact on oil prices and the economy is also short-term, making it unlikely to change monetary policy direction. Currently, the Fed is in the “last mile” of a rate-cut cycle; the peak of oil prices or the timing of resuming rate cuts are key.

(3) Easing of geopolitical conflicts is favorable for oil price peaks, but the “self-reinforcing” effects of oil prices, finance, and the economy should not be ignored

Oil prices have become the “anchor” for asset pricing. The two core variables in oil pricing are geopolitical risk premiums and fundamentals. While markets are closely watching Middle Eastern developments, the “self-reinforcing” power of the oil price–financial–economic cycle should not be overlooked: inflation triggered by supply shocks will suppress aggregate demand through mechanisms like real income, financial conditions, or wealth effects, thereby restraining oil prices.

The market is already caught in a “negative feedback” loop involving oil prices, finance, and the economy. When market expectations for Fed rate cuts are overly pessimistic (e.g., expecting rate hikes this year), the actual likelihood of rate cuts may be higher. In the medium term, a scenario unfavorable to monetary and financial conditions is: conflicts are temporary, but the increase or persistence of the oil price center post-conflict exceeds expectations.

Risk warnings: escalation of geopolitical conflicts; US economic slowdown exceeding expectations; Fed hawkish surprises.

Main Report

Since the Middle Eastern geopolitical conflict at the end of February, crude oil prices have continued to rise, raising concerns about stagflation. The March FOMC meeting adopted a hawkish stance, triggering tightening trades, and the market began to speculate on whether the Fed will raise interest rates this year. The Fed’s hawkish policy stance aligns with expectations, but “no rate cuts” remains the “bottom line,” with ongoing attention on the negative feedback from tightening financial conditions.

(1) The market is betting on a 2026 rate hike by the Fed, but it remains a “low-probability event” for now

The “long-termization” of Middle Eastern conflicts and the sustained rise in oil prices are increasing the risk of stagflation. As of March 19, Brent crude spot prices had risen to $111/barrel, up $40 (about 56%) from just before the conflict (Feb 27, $71), and up $50 (about 82%) from the end of 2025 ($61). Compared to the average in March 2025 ($72), the increase is $39 (about 54%). Cost shocks have driven wholesale and retail fuel and gasoline prices in the US higher, far exceeding crude oil increases. This has sparked concerns about US “de-inflation” prospects and monetary tightening—though inflation caused by supply shocks is temporary, its persistence depends on whether the supply shock is temporary and how demand responds.

The March FOMC confirmed and reinforced market fears of tightening. The policy tone was hawkish; for example, Powell indicated that progress on inflation is a prerequisite for considering rate cuts. Risks of rising inflation mainly stem from two sources: first, tariff transmission is expected to improve only by mid-2026, slightly later than expected; second, uncertainty in Middle Eastern geopolitics and high oil price volatility. The March economic projections revised upward the 2026 and 2027 core PCE inflation forecasts by 0.2 and 0.1 percentage points to 2.7% and 2.2%, respectively, maintaining the 2026 unemployment rate forecast at 4.4%. Based on the balance of inflation and employment risks, Powell believes “it’s hard to say which side’s risk is greater,” so a “higher neutral interest rate” is appropriate, and he retains the guidance of one rate cut within the year, but emphasizes that inflation progress is a prerequisite for rate cuts.

After the March FOMC, US financial stress increased markedly, and the market began to speculate on the likelihood of the Fed raising rates again. The hawkish stance reinforced “tightening trades”: US stocks and commodities like gold and copper fell sharply, US Treasuries stabilized in a “bear flattening,” and the dollar strengthened. As of March 20, although the probability of no rate cuts in 2026 remains above 80%, the probability of a 25bp rate hike increased from 0% to 12% over the past month, while the chance of a 25bp cut dropped from 17% to 0%. The most likely timing for a rate cut is now pushed back to September 2027, with only a 37.5% chance, showing a “fat tail” characteristic.

We believe that not cutting rates or maintaining a hawkish stance in 2026 is the “bottom line”—a rate hike is extremely unlikely. Moreover, the more pessimistic the market’s pricing, the greater the actual chance and room for the Fed to turn dovish. This is mainly because: first, conditions for a “great stagflation” similar to the 1970s are insufficient; supply shocks causing inflation are temporary—unlike the 2022 Russia-Ukraine conflict; second, short-term inflation pressures will be suppressed through mechanisms like real income, financial conditions, wealth, and expectations, creating a “self-reinforcing” effect. Overall, if the Middle Eastern conflict is short-lived (1-2 months), oil prices will gradually decline, possibly delaying rate cuts but not changing the overall direction; if the conflict persists longer or oil prices stay high longer than expected, the “self-reinforcing” effect could trigger recession fears, and even if geopolitical conflicts do not end, oil prices may fall, opening space for rate cuts.

(2) Supply shocks to crude oil are unlikely to cause “great stagflation,” but oil price peaks or the resumption of rate cuts are preconditions for easing

The US does not have the conditions to recreate the “great stagflation” of the 1970s. If Middle Eastern conflicts escalate to extreme scenarios, the US economy is more likely to face recession rather than stagflation. The core mechanism of stagflation is the “wage-price spiral”—profit-price spiral is fragile because inflation caused by supply shocks is sustainable only if wages follow inflation. The 1970s’ “great stagflation” fits this mechanism, but today’s US does not meet these conditions: 1) medium- and long-term inflation expectations remain anchored; 2) union bargaining power is lacking; 3) the Fed is more independent. The 2022 Russia-Ukraine conflict was an extreme stress test. With oil prices reaching an average of $123/barrel, delayed Fed rate hikes, active fiscal policies, ample excess savings, and a tight labor market, the spillover effects of oil price increases were manageable—the CPI peak and oil price peak both occurred in June 2022, with core CPI peaking in September.

Faced with inflation pressures from supply shocks, the Fed’s stance leans toward focusing on short-term inflation risks, acting cautiously—initially “keeping steady,” then adjusting as needed. The cases of the 1973-74 oil crisis and the 2003 Iraq War show different responses: in 1973-74, the Fed was more concerned about unemployment and recession risks; in 2003, it focused more on deflation risks. Neither case is directly comparable to today. The former was based on Keynesian economics and a skewed Phillips curve; the latter occurred in a “jobless recovery” environment after the tech bubble burst, with oil prices not soaring significantly, and inflation only rising from 1.5% (September 2002) to about 3%.

During the 1990-1991 Gulf War, the Fed was hawkish, willing to accept recession to wait for oil prices to peak before easing. After Iraq’s invasion of Kuwait in August 1990, Brent oil surged from below $20 to over $40, and CPI rose from 4.8% to over 6%. The Fed had already begun rate cuts in mid-1989. After the conflict, Greenspan initially paused rate cuts, then resumed in October 1990 as oil prices fell, about three months after the recession started. In January 1991, Iraq’s attack on Israel intensified geopolitical risks, but oil prices briefly spiked then quickly declined amid a recession, so the Fed’s rate cuts continued unaffected.

The 2022 Russia-Ukraine conflict and rising oil prices are key explanations for the Fed’s “front-loaded” rate hike cycle. Before the conflict, Brent prices rose from $18.4 in April 2020 to $97 in February 2022. After the conflict, prices peaked at $123 in June (with a high of $138 in March). The Fed began rate hikes in March 2022, with subsequent increases (25bp in March, 50bp in May, and four 75bp hikes from June to November) closely linked to oil prices. From the start of rate hikes to the end of 2022, recession risks increased, but the Fed remained focused on inflation control and anchoring inflation expectations.

Analysis shows that when facing supply-driven oil price increases, the Fed tends to focus on short-term inflation risks, often pausing rate cuts or raising rates faster during hikes. Since WWII, geopolitical conflicts tend to be short-term, and their impact on oil prices and the economy is also short-term. The Fed generally “keeps steady” until the situation clarifies—balancing employment and inflation risks (both current and expected). Currently, the Fed is in the “last mile” of a rate-cut cycle (similar to the Iraq War case), with the timing of oil price peaks or rate cuts being critical.

(3) Easing of geopolitical conflicts is favorable for oil price peaks, but the “self-reinforcing” effects of oil prices, finance, and the economy should not be overlooked

Since the US-Israel attack on Iran on February 28, oil prices have become the “anchor” for asset pricing. Market attention is focused on the possibility of conflict escalation, damage to oil infrastructure, Strait of Hormuz navigation, and the potential center of oil prices after conflict easing. However, the “self-reinforcing” power of the oil price–financial–economic cycle should not be ignored: inflation caused by supply shocks will suppress demand through mechanisms like real income, financial conditions, or wealth effects, thereby restraining oil prices. The Gulf War and Russia-Ukraine cases both show that supply shocks can cause stagflation pressures, with financial conditions tightening (hawkish Fed stance, rising US bond yields, stock corrections, widening credit spreads), which further depress economic activity and eventually lead demand to “overcome” supply, causing oil prices to fall and creating room for the Fed to turn dovish and ease financial conditions.

During the Russia-Ukraine conflict, oil prices showed a “double top,” with the first peak in March roughly coinciding with geopolitical risk index peaks, mainly reflecting a “downgrade” of conflict severity. However, prices did not continue to decline with risk reduction; instead, they rose against the trend in May and June, then entered a long-term downtrend amid recession fears. Besides fundamentals, policy, and technical factors, the main signs of increased financial stress before and after oil prices started to fall in mid-June include: 1) global central banks began “rate hikes,” with the Fed raising rates by 75bp in June; 2) the dollar strengthened; 3) 10-year US Treasury yields peaked and then declined, the 10Y-3M spread narrowed, and 2-year TIP yields turned positive; 4) US stocks declined sharply.

Since the Middle Eastern conflict began in late February, US financial conditions have tightened, accelerated by the March FOMC. The “self-reinforcing” cycle of oil prices, finance, and the economy will exert downward pressure on oil prices from the demand side, creating room for the Fed to turn dovish. In summary: first, the conditions for the US to repeat the 1970s “great stagflation” are very insufficient; second, supply shocks will “eliminate” demand and limit oil price increases; third, rising financial stress will accelerate risks in private credit markets. We are in a “negative feedback” loop: when market expectations for rate cuts are overly pessimistic (e.g., expecting rate hikes this year), the actual likelihood of rate cuts may be higher. Similar to the rate cut cycles starting in September 2024 and September 2025, these are driven by employment risks. Currently, employment risks exist, compounded by private credit risks, so unless an extreme “great stagflation” scenario occurs, we remain cautiously optimistic about rate cuts within this year. A scenario unfavorable to liquidity is that conflicts are temporary but lead to unexpectedly high or persistent oil price centers.

Risk warnings:

1. Escalation of geopolitical conflicts. The Russia-Ukraine conflict is ongoing, and further escalation could increase oil price volatility, disrupt global “de-inflation” efforts, and hinder a soft landing.

2. US economic slowdown exceeding expectations. Watch for risks of weakening employment and consumption.

3. Hawkish surprises from the Fed. If US inflation proves more resilient, it could impact the Fed’s future rate cut pace.

THE END

Excerpt from Shenwan Hongyuan Macro Research Report:

“Not Cutting Rates or the Fed’s ‘Bottom Line’—‘Liquidity Notes’ Series No. 9”

Securities Analysts:

Zhao Wei, Chief Economist at Shenwan Hongyuan Securities

Chen Dafei, Chief Macro Analyst

Zhao Yu, Senior Macro Analyst

Wang Maoyu, Senior Macro Analyst

Li Xinyue, Senior Macro Analyst

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