Energy crisis puts interest rate hikes back on the agenda

With the conflict in the Middle East bogged down, economic growth has stalled as inflationary pressures intensify – an explosive cocktail that has sent bond yields higher.

Sliding eurozone consumer confidence indicators since the start of the conflict signalled falling momentum in the region. The slowdown in eurozone growth for the first quarter to an annualised 0.6% thus came as no surprise. Amongst the major European economies, the German economy put in a good performance to grow 1.3%, fuelled by steady consumer and public spending in the context of the country’s expansionary fiscal policy. In contrast, France disappointed. Its GDP stagnated over the quarter, as households reined in spending and the construction sector contracted.

The outlook darkens

The closure of the Strait of Hormuz for more than two months has significantly darkened the outlook for growth in Europe. The eurozone PMI leading indicator slipped further to 48.8, past the 50-point mark, signalling the growing weakness in the services sector as consumer demand falters. Although manufacturing held up well, it’s important not to read too much into it, since firms were front-loading orders to get ahead of rising prices and possible supply chain disruption.

Tightening monetary policy in the eurozone

The German 2-yr bond yield has risen to almost 2.75%, up more than 0.6% since the start of the year on expectations that the ECB will tighten monetary policy. Markets are pricing in two to three rate hikes by the end of 2026, with the first hike expected as early as June. Long-term yields are also trending upwards, driven by renewed inflation worries. Markets have revised German inflation expectations and are now pricing in a 10-year average of close to 2.3% (vs. 1.75% at the start of the year).

What’s more, the ECB’s latest survey on eurozone bank lending showed even tighter lending conditions for businesses during the first three months of the year. Fuelled by sharper risk aversion in the banking sector, this caution is expected to last through the second quarter of the year.

Source: ECB, Banque de Luxembourg

Oil stays above $100 a barrel

Brent crude, the global pricing benchmark derived from North Sea oil, stabilised over recent weeks below its recent high at close to $110. There are two reasons for this relative calm on the price front: surging shipments of US oil to meet demand, and reduced oil imports by China as it releases more of its oil stockpile. However, neither of these two factors seems likely to last. With the rapid depletion in global inventories, it is vital to reopen the Strait in the next few weeks to prevent another oil price spike.

Resilient US economy

US gross domestic product grew at an annualised rate of 2% in the first quarter of 2026, underpinned by a modest 1.6% increase in consumer spending. The latest consumption index, particularly retail sales data for April, shows no sign of a more marked slowdown in spending – at least for now. Sizeable tax refunds – a result of the One Big Beautiful Bill Act, which introduced tax cuts retroactive to 2025 – are bring some relief to households as they grapple with inflation. Massive tech sector investments continue to shore up the US economy, contributing more than 1% to growth in the quarter. The trend is set to continue. Meta Platforms, Microsoft, Google and Amazon all upped their CAPEX guidance in their Q1 earnings publications. Taken together these investments amount to in excess of $700 billion in 2026.

Labour market shows no clear signs of running out of steam

In line with expectations, the US private sector added 123,000 jobs in April. More broadly, the average monthly gain from February to April was 55,000 jobs, which was sufficient to keep the jobless rate from ticking up. Nonetheless, there is significant sector concentration with healthcare and social assistance creating the most jobs.

Monetary policy unchanged; interest rates tick up

The Federal Reserve held steady on its monetary policy against a complex background of a resilient economy and labour market, and soaring inflation – the consumer price index rose 3.8% annually in April, the highest since 2023.

Mirroring trends in the eurozone, short-term rates have rebounded. The 2-year yield has risen by more than 0.6% since the start of the year, while 30-year yields have hit their highest level since 2007. The economy inherited by newly appointed Fed Chair Kevin Warsh will no doubt stay his hand on delivering the monetary easing hoped for by the Trump administration.

Source: Bloomberg, Banque de Luxembourg

Equity euphoria despite pressure on rates

Equity markets have rebounded sharply since early April, despite significant pressures in the bond markets and poor visibility as to how the Middle East conflict might play out. There are two main reasons why equities are riding so high; the robust profits announced in excellent corporate Q1 results, especially in the US, and the continuing very bullish investor interest in AI. But, concentrated in a small number of equities, this euphoria is fragile.

Damien Petit, CFA, Head of Private Banking Investments,
Banque de Luxembourg