Middle East Tensions Reshape Rate Cut Bets

Market Recalibrates Rate Cut Expectations Amid Middle East Turmoil

The escalating conflict in the Middle East has upended global financial markets, forcing traders to dramatically reassess the trajectory of interest rates. Just weeks ago, markets were pricing in two rate cuts by the Reserve Bank of Australia (RBA) for 2026. Now, those expectations have been all but extinguished, with swaps indicating zero probability of easing this year. The shift underscores how geopolitical risk is feeding through to inflation expectations, complicating the policy outlook for central banks worldwide.

According to Sarah Hammoud, currency strategist at Commonwealth Bank of Australia, the key risk lies in core inflation proving stickier than consensus forecasts. “The risk is that core inflation is stronger than consensus expectations because of spillover from energy prices to other prices such as airfares and food,” she said. Hammoud’s warning highlights a transmission mechanism that could keep the RBA on hold even as the Australian economy shows signs of cooling. Energy costs have surged since the outbreak of hostilities, with Brent crude spiking above $95 per barrel, and analysts expect further volatility if the conflict widens.

Original Analysis: A Deeper Dive into the Inflation Spillover

Beyond the immediate energy price shock, the Middle East crisis is likely to exert upward pressure on a broader range of goods and services. Shipping disruptions through the Strait of Hormuz, a chokepoint for 20% of global oil supply, have already raised transportation costs. These increases are gradually feeding into consumer prices for imported goods, from electronics to clothing. In Australia, where the RBA has been battling above-target inflation for two years, this fresh wave of cost pressures could delay any pivot to looser policy well into 2027.

Historically, the RBA has been cautious about responding to supply-side shocks, preferring to look through temporary spikes. However, the current episode differs in two key respects. First, the shock is superimposed on an economy already operating with limited spare capacity, with the unemployment rate at 3.9%. Second, inflation expectations have become less anchored, as evidenced by the Melbourne Institute’s consumer inflation expectations rising to 4.2% in April. If the Middle East conflict persists, the RBA may be forced to acknowledge that the inflation battle is not yet won, potentially leading to a hawkish pivot in its forward guidance.

For Australian borrowers, the implications are stark. Mortgage holders hoping for relief later this year may have to wait until 2027 or longer. The Australian dollar has also felt the impact, initially strengthening on safe-haven flows but now facing headwinds from a stronger US dollar. The AUD/USD pair has retreated from $0.6700 to $0.6520, reflecting both risk aversion and the widening interest rate differential with the US.

Market Implications and Forward Outlook

The repricing of rate expectations has been most pronounced in the bond market. Australian government bond yields have risen sharply, with the 3-year yield climbing 40 basis points since the conflict erupted. This has increased borrowing costs for businesses and homeowners, threatening to dampen economic activity further. On the other hand, higher yields have attracted foreign capital, providing some support for the currency.

Looking ahead, the RBA’s next policy meeting in June will be closely watched for any shift in language. Governor Michele Bullock has stressed that policy remains data-dependent, but the bank’s internal models may now need to incorporate a more persistent inflation scenario. If oil prices remain elevated, the RBA could be forced to raise its inflation forecasts, potentially opening the door to further rate hikes—a scenario that seemed unthinkable just months ago.

Sources: CNBC

1. Markets have fully priced out rate cuts for 2026, compared to two cuts expected before the Middle East conflict.
2. Core inflation risks are elevated due to energy price spillovers into other sectors like airfares and food.
3. The RBA is likely to remain on hold for an extended period, with potential for a hawkish pivot if inflation persists.