Inflation intensifies amid energy price shock, though diplomatic horizons offer a faint glimmer

Inflation intensifies amid energy price shock, though diplomatic horizons offer a faint glimmer

Highlights

• Headline CPI accelerated sharply in April to 3.8% YoY and 0.6% MoM, up from March’s 3.3% and 0.3%, primarily driven by surging energy costs following the Strait of Hormuz blockade.
• The U.S. labor market remained resilient, adding a solid 115,000 nonfarm payrolls in April after March’s strong 185,000 gain, with the unemployment rate held steady at 4.3%.
• Oil prices corrected modestly after President Trump announced the postponement of a major military strike on Iran and signaled peace talks are in the final stages.
• The 10-year Treasury yield surged 20–30 basis points in May to a 16-month high of 4.6–4.7%, driven by hotter inflation, repricing of Fed policy expectations, and rising fiscal concerns.
• Global oil inventories are depleting rapidly and are expected to reach critically low levels between June and September, keeping upward pressure on oil prices.
• Higher oil costs are feeding through to petroleum-based products, fertilizers, and food, making inflation vulnerable to further upside risks.
• Ongoing U.S.-Iran peace talks offer hope for averting a prolonged crisis, with Iran proposing a phased reopening of the Strait in exchange for sanctions relief, asset unfreezing, and removal of the naval blockade.
• Major sticking points remain — particularly Iran’s enriched uranium transfer and demands for substantial transit toll fees — making full reopening unlikely in the near term.
• A phased agreement would allow oil prices to gradually decline to $80–95/bbl over the next 2–3 months, but risks leaping sharply higher to $120–150/bbl if negotiation enters deadlock.
• Oil-driven inflation, resilient labor data, and elevated fiscal risks set to veto Warsh’s dual mission of rate cut and balance sheet tightening in the near term.
• Anchored by higher inflation, a further yield surge leaves stocks, bonds, and gold vulnerable to a renewed selloff.
• The Hang Seng Index hovered between 25,000 and 27,000, with robust daily turnover of HK$260–300 billion, fueling standout performance across the AI model, cloud, robotics, and autonomous driving sectors.

Intensified oil-driven inflation assault

Headline CPI surged to 3.8% year-over-year and 0.6% month-over-month in April, a significant acceleration from March’s 3.3% and 0.3% readings. This uptick was precipitated by soaring energy costs following the reciprocal blockade of the Strait of Hormuz by Iran and the United States. Energy prices spiked 3.8%, contributing to over 40% of the total headline increase. A granular examination of the surge reveals a 5.4% jump in the gasoline index, alongside a 2.1% rise in electricity costs. Inflationary momentum is permeating broader sectors, with food prices rising by 0.5%, and hotel and airfare costs both climbing 2.8%, signaling the emergence of more widespread inflation. Excluding the volatile food and energy components, the Core CPI rose 2.8% YoY and 0.4% MoM, stepping up from the previous month’s 2.6% and 0.2%. Shelter costs remain the primary irking source, surging 0.6% on a monthly basis. Furthermore, trade tariffs continue to exert upward pressure, with the apparel category increasing 0.6% and household furnishings and operations rising 0.7%.

Labor market held up amid geopolitical strife

Despite geopolitical uncertainties, the labor market demonstrates remarkable vigor. Nonfarm payrolls expanded by a robust seasonally adjusted 115,000 in April, following March’s exceptional gain of 185,000. Healthcare led the sectoral growth with 37,000 new positions, followed by transportation and warehousing (30,000), retail (22,000), and social assistance (17,000). Conversely, information services shed 13,000 jobs, and government payrolls contracted by 9,000. The unemployment rate remained steady at 4.3%, while average hourly earnings moderated, rising 0.2% for the month and 3.6% annually.

Crude prices retreat on renewed diplomatic optimism

Oil prices corrected modestly following President Trump’s announcement to postpone a planned large-scale military strike against Iran in favor of negotiations. Signaling that talks are in the “final stages,” the President suggested a swift resolution to the conflict could be at hand. These hopes for a diplomatic breakthrough reduced the geopolitical risk premium, prompting WTI and Brent crude to retreat by 5% and 8%, respectively, settling at $105 and $114 per barrel.

Treasury yields spike on hotter inflation, higher for longer rates, and fiscal anxiety

The 10-year Treasury yield surged 20-30 basis points in May, reaching a 16-month high of 4.6–4.7%. This rise stems from a confluence of factors: energy-shock-driven inflation, a dramatic repricing of Federal Reserve rate expectations, and mounting apprehensions regarding U.S. fiscal health. Disruptions in the Strait of Hormuz and broader Middle Eastern tensions have elevated energy costs, reigniting inflationary pressures and rate hike odds by late 2026. Therefore, investors are selling bonds for rotating to higher yield new bonds. Additionally, the U.S. Treasury issued $9.14 trillion in short-term bills during the first four months of 2026—the highest volume since the 2008 financial crisis—pushing total national debt past $39 trillion. With projected deficits and the debt-to-GDP ratio estimated to hit $1.9 trillion and 5.8% respectively in 2026, heightened fiscal deficit concerns have resulted in weak auction demand, fueling a rise in longer-term yields as investors demand greater risk compensation.

Predictions

1.Elevated inflation near-term

The effective closure of the Strait of Hormuz has disrupted 10–15 million barrels per day (mb/d) of crude oil and petroleum products from major Gulf producers, including Saudi Arabia, the UAE, Iraq, Kuwait, and Iran. Although mitigation measures — such as ramped-up flows through bypass pipelines (Saudi East-West and UAE Habshan-Fujairah, totaling approximately 3.5–5.5 mb/d), Strategic Petroleum Reserve releases, higher output from the U.S. and other non-OPEC producers, and global inventory draws — have helped offset part of the loss, the market continues to face a significant net supply deficit of several million barrels per day.  Inflation is vulnerable to further upside as global oil reserve is depleting and higher oil prices permeate the price of petroleum-based products, fertilizer and food.

2.Zig-zag oil price under phrased opening negotiation, sky-high risk remains

The ongoing peace talks following the U.S.-Iran ceasefire provide a potential silver lining for averting a damaging prolonged stalemate. Iran has proposed a partial or phased reopening of the Strait of Hormuz in exchange for U.S. concessions. Tehran has signaled willingness to lift the blockade and defer nuclear negotiations to a later stage, provided the U.S. removes its naval blockade on Iranian ports, releases frozen assets, and lifts oil sanctions.Under pressure from elevated oil prices, President Trump has indicated flexibility for a limited interim agreement focused primarily on quickly reopening the Strait, even if broader issues — such as nuclear enrichment and regional proxies — are deferred.

That said, we believe the Strait is unlikely to reopen fully in the near term. Significant disagreements persist, particularly regarding the transfer of Iran’s enriched uranium to third countries and Iran’s demand to impose substantial toll fees on vessels transiting the Strait. These sticking points point to a highly volatile oil price environment in the coming weeks as negotiations continue with frequent setbacks.

Base Case: Should the U.S. and Iran reach an agreement on a phased reopening, we expect oil prices to gradually decline toward the $80–95 per barrel range over the next 2–3 months. This would be consistent with historical patterns, where positive negotiation headlines have triggered $10–20+ declines. However, an immediate crash to the $60–75 range is unlikely due to logistical delays in restoring full physical supply. The main downside risk to this scenario is prolonged deadlock over nuclear concessions.

Risk Case: Global usable inventories (strategic and major commercial stocks), estimated at roughly 3–4 billion barrels, are projected to reach critically low levels between June and September. If negotiations drag into late summer and the Strait remains largely closed until September, physical shortages could drive oil prices sharply higher, potentially surging to $120–150 per barrel.

3.Warsh’ dual mandate of fiscal tightening and rate cut urgency to delay

The new Fed Chair Kevin Warsh has long advocated for a reduced balance sheet (quantitative tightening) alongside lower short-term policy rates. However, the current macroeconomic backdrop—characterized by oil and geopolitical shock-induced inflation, rising Treasury yields, a resilient labor market, and elevated fiscal fragility—renders this dual proposal difficult to implement in the near term.

Markets currently price in few or no cuts in 2026, or even potential hikes by year-end. Given the oil shock and hotter inflation data, we posit that Warsh will delay anticipated rate cuts to prioritize taming inflation until a phased or partial reopening of the Strait materializes in the coming months. Should peace talks disappoint and progress stall, we believe the Fed will likely hold rates steady through the remainder of 2026. While we do not rule out modest rate hikes if inflation remains persistently high, the Fed may refrain from aggressive tightening as the U.S. can modestly boost domestic shale production to support internal supply and limit import dependence.

On the balance sheet front, the arithmetic is equally challenging. The U.S. government’s enormous debt load—now exceeding $39 trillion—necessitates massive ongoing Treasury issuance. Reducing the Fed’s balance sheet would remove a key buyer from the market, pushing long‑term yields even higher and elevating mortgage rates and borrowing costs across the economy—outcomes that would be detrimental to both the stock market and broader economic growth. Accordingly, we believe Warsh will pursue a gradual, cautious approach to balance sheet normalization, avoiding any aggressive reduction that could destabilize already‑skittish bond markets.

4.Stock, bond and gold fall victim to potential further yield surge

Yields could rise further if the Hormuz disruption persists, pushing oil and inflation higher while amplifying rate-hike odds and inflation risk premiums. We see room for additional yield increases if inflation keeps surging as it did during COVID in 2023 (highest yield~5%). Higher yields directly pressure stock valuations, depress bond prices, and raise the opportunity cost of holding non-yielding gold—making all three assets vulnerable to a renewed selloff.

Disclaimer

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