The rise in oil prices does not necessarily mean that the Federal Reserve will shift to a hawkish stance. Bank of America Merrill Lynch warns that the market is misinterpreting the Federal Reserve's policy response.
Since the outbreak of the Iran conflict, the yield on 2-year U.S. Treasury bonds has risen in tandem with oil prices, with the market directly pricing supply-side shocks as signals for tightening monetary policy.
According to the morning market update released by Bank of America Merrill Lynch on March 10, this logic has fundamental flaws: supply shocks threaten both ends of the Federal Reserve's dual mandate, and the uncertainty of the policy path thus expands in both directions, rather than being unilaterally hawkish.
Bank of America Merrill Lynch economist Aditya Bhave points out that the current macroeconomic backdrop is vastly different from that of 2022— the labor market is relatively soft, inflation is moderate, and fiscal stimulus is limited. If the oil price shock persists, the Federal Reserve is more likely to respond in a dovish manner, rather than repeating the aggressive rate hike path of 2022.
<h2>The market directly prices the rise in oil prices as a hawkish signal</h2>
Since the outbreak of the Iran conflict, the yield on 2-year U.S. Treasury bonds has closely followed the trend of WTI crude oil prices, with the market's implied logic being that rising oil prices boost inflation expectations, thereby forcing the Federal Reserve to maintain high interest rates or even restart rate hikes. The only exception occurred on the Friday following the weak non-farm payroll data release in February, when yields briefly deviated from oil price trends.
Bank of America Merrill Lynch believes that this pricing approach overlooks the dual nature of supply shocks. Supply-side shocks can raise inflation while also suppressing economic growth and employment, thereby creating opposing pressures on the Federal Reserve's dual mandate—price stability and full employment.
This pressure thickens the &#34;tails&#34; of the policy distribution: the probability of extending the pause in rate hikes increases, there is a tail risk of rate hikes, but the risk of significant rate cuts should not be ignored either.
<h2>Why the 2022 script is difficult to replicate</h2>
Bank of America Merrill Lynch emphasizes that the premise for the right-tail policy risk (i.e., the Federal Reserve turning hawkish due to rising oil prices) is that economic demand is strong enough to withstand supply shocks without significant slowdown, allowing the Federal Reserve to focus on inflation. When the Russia-Ukraine conflict broke out in 2022, this condition was met: the unemployment rate was below 4%, core PCE inflation exceeded 5%, non-farm payrolls added an average of about 500,000 jobs per month, and consumers had a substantial amount of cash accumulated from pandemic-related fiscal support.
The current environment stands in stark contrast to that time. Bank of America Merrill Lynch points out that the labor market is currently soft, inflation is at a moderately high level, and fiscal support is relatively limited. In this context, if the oil price shock is persistent, the Federal Reserve is more likely to adopt a dovish response rather than tightening policy in line with market expectations.
<h2>Policy uncertainty expands in both directions</h2>
Bank of America Merrill Lynch's core judgment is that rising oil prices &#34;thicken the tails of the policy distribution,&#34; rather than pushing the probability mass unidirectionally toward the hawkish end. Specifically, the likelihood of extending the pause in interest rates increases, rate hikes remain a tail risk, but if supply shocks continue to drag down growth, the risk of deep rate cuts also rises.
The current macroeconomic fundamentals determine that the Federal Reserve's sensitivity to oil price shocks is not comparable to that of 2022. If the market continues to price based on the old script, it may face the risk of directional misjudgment
At the macro data level, Bank of America Merrill Lynch has revised its first-quarter GDP tracking estimate down from the previous official forecast of 3.3% to 2.9% (seasonally adjusted annualized quarter-on-quarter), mainly due to weaker-than-expected retail sales in January and non-farm employment data in February. Among them, the personal consumption expenditure tracking value has decreased from 2.2% to 1.8%, and residential investment has dropped from 1.5% to 1.0%.
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Bank of America Merrill Lynch warns that rising oil prices do not necessarily mean the Federal Reserve will shift to a hawkish stance, and the market may misunderstand the Fed's policy response. The current macro environment is different from that of 2022, with a soft labor market and moderate inflation. If the oil price shock persists, the Fed's response may lean towards dovish rather than repeating the aggressive rate hike path of 2022. Supply shocks simultaneously threaten the Fed's goals of price stability and full employment, leading to increased uncertainty in the policy path

- Bank of America Merrill Lynch warns that the market may be misinterpreting the Federal Reserve's response to rising oil prices following the Iran conflict.  
- They argue that supply shocks simultaneously threaten both inflation and employment, suggesting a more dovish policy response rather than a hawkish shift typical of 2022.  
- Current economic conditions differ significantly from 2022, with a weaker labor market and moderate inflation likely leading to increased uncertainty in policy outcomes.

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Oil prices soar = Hawkish Federal Reserve? Bank of America: The market may be misjudging, and the 2022 script is hard to repeat