Global macro outlook dominated by Middle East conflict, with two-way risks for interest rates, exchange rates, and commodity prices

Overview

This report is J.P. Morgan's mid-May update on the global macro landscape. The central thesis is that the Middle East conflict has become the dominant factor driving global interest rates, exchange rates, and commodity prices. The report expects U.S. rates to rise overall (2-year to 3.85%-3.90%, 10-year to 4.40%-4.50%), with the Fed on hold in 2026, but emphasizes that current yield levels are already at the high end of pre-conflict ranges, with downside risks if a durable peace solution is achieved. The report expresses caution on the global outlook, noting rising stagflation risks in emerging markets while maintaining a modest overweight in EM assets, highlighting the need for risk management via derivatives and structured positions.

Core views

U.S. rate outlook is supported by slow labor market improvement and the Fed's hawkish rhetoric. The report expects the Fed to keep benchmark rates at 3.5%-3.75% for the full year, with no rate hikes until 3Q27 (assuming labor market tightens and inflation remains above target). 2-year yields should rise from 3.85% (1H26) to 3.90% (year-end), and 10-year yields from 4.40% to 4.50%. However, current yields are already at the high end of pre-conflict ranges, lacking justification for pure short positions; durable Middle East resolution would pose clear downside risks. Oil prices are a key uncertainty for the global outlook. Analysis shows that, given continued OECD inventory drawdowns, oil should remain mostly in the low $100 range, with a 2026 average of $97/barrel. The key assumption is the Strait of Hormuz reopening in early June, but the report sees low probability for sustainable negotiations or quick reopening, with tail risks skewed toward continued closure and escalation. Even if the strait reopens in June, structural tightness will persist into 2H26. For LNG, despite global price increases, TTF discounts to JKM have widened, favoring U.S. spot LNG flows to Asia. FX markets face multiple uncertainties, making clear directional calls difficult. The dollar outlook depends on Middle East developments, interpretation of U.S. short-term rate prospects, and whether global growth is affected by Hormuz closure, all of which complicate directional views. The report recommends maintaining carry trade-friendly positioning, leveraging market asymmetry (gains on up days exceed losses on down days). For JPY, Japanese authorities have drawn a line at 160 but cannot reverse medium-term depreciation; year-end target remains 164. If 162 is reached pre-intervention, authorities may act again. Fed-MOF coordination gives the impression of joint USD-JPY stabilization, but U.S. policymakers' appetite for a weak dollar is complicated by post-Iran inflation. Emerging markets face stagflation risks and rising valuation pressures. Higher Middle East oil prices and asymmetric Fed reaction (lowering real rates) initially supported EM assets, but the report has downgraded demand forecasts for EM FX, local rates, and sovereign credit. Risk premia have fallen significantly in implied volatility. EM spot rates are rising but fundamentals deteriorating, limiting the risk-reward of chasing disinflation trades. The report favors curve and relative value opportunities, as well as specific IRS stories (Hungary, Brazil, Poland, Mexico, Colombia). EM sovereign and corporate bonds show resilience, but this should be seen as reflexive adjustment before real economic damage appears, not fundamental improvement, hence recommending EM CDS hedges.

Analysis framework

The report employs a multi-layered framework. For rates, it benchmarks current yields against Fed funds futures, OIS curves, and real yields to assess positioning attractiveness. Attribution analysis decomposes 5s/30s curve changes into Fed hawkishness (1y1y OIS up 77bp), term premium adjustments, and other factors to judge steepening sustainability. For oil and supply chains, the report builds a pricing framework based on OECD inventory trajectories and strategic reserve release needs, concluding that even Hormuz reopening won't quickly normalize markets. Nickel analysis uses cost curve methodology, showing how industry C1 cost boundaries and minimum profit margins lock prices at high levels, making them vulnerable to supply shocks (e.g., Indonesian quota cuts, sulfur price hikes). FX assessment combines intervention analysis (cost per JPY), macro fundamentals (fiscal differentiation, current account dynamics), and event risks (U.S.-China summits, Treasury visits). EM asset views incorporate reflexivity—asymmetric risk sentiment (up days outperform down days) implies asymmetric capital flow responses, necessitating derivative hedges and timing adjustments.

Methodology notes

• Macroeconomic frameworkSupply-demand framework

  Oil price analysis based on OECD inventory dynamics and strategic reserve release needs

  The report decomposes oil price determination into supply (inventory changes, reserve releases) and demand (global growth). Hormuz closure accelerates OECD inventory draws, creating structural tightness even with weak demand. This framework explains why reopening won't normalize prices quickly—inventory rebuilding takes months, sustaining premiums.

• Corporate Fundamentals & Financial FrameworkCost curve analysis

  Nickel prices anchored to upper C1 cost curve: limited downside, quick upside to cost shocks

  The report focuses on nickel production costs. Global cost distribution shows marginal producers with thin margins, keeping prices near the curve's upper end. Any cost increase (e.g., Indonesian quotas, sulfur prices) quickly translates to higher prices, as margins can't absorb cost growth. This explains how Middle East shocks (fuel, fertilizer costs) multiply into nickel price effects.

• Event Gaming & Behavioral FinanceAsymmetric Risk Sentiment

  Market exhibits more aggressive buying on up days (larger gains) vs. selling on down days (smaller losses), reflecting one-way positioning in risk assets

  The report observes asymmetric volatility in USD and risk assets over three months: up-day moves exceed down-day moves. This suggests participants chase returns more aggressively in risk-on environments, supporting 'maintain carry trade-friendly' recommendations.

• Valuation methodsFair Value Model

  Multi-factor regression for 10-year Treasury fair value: Fed balance sheet, 1y1y OIS, 5y5y TIPS breakevens, trade policy uncertainty

  The report quantifies 10-year fair value via factors: Fed balance sheet/GDP (liquidity premium), 1y1y OIS (policy expectations), 5y5y TIPS (inflation expectations), and trade policy dummies. This helps assess whether current yields (4.36%) fully reflect conflict risks.

• Macroeconomic frameworkFiscal Differentiation

  G10 fiscal deficit dispersion and FX correlation: higher-deficit currencies depreciate

  Middle East conflict may widen global deficits (defense spending, oil-driven inflation support), reviving 'fiscal differentiation' as a DM FX driver. Transmission has shifted from term premia to current accounts. High-deficit currencies face depreciation, explaining limited USD upside despite U.S. fiscal expansion.

• Fixed Income & Credit AnalysisSpreads & Asset Quality

  EM credit spread (EMBIGD) resilience despite deteriorating fundamentals reflects delayed market pricing of economic damage

  EM sovereign spreads widened 40bp post-conflict (March peak) but quickly tightened to 242bp, near 13-year lows. This resilience reflects 'reflexive adjustment' before real damage appears, supporting 'buy EM CDS hedges'—spreads will re-widen when stagflation threats materialize.

Key data

• 2-year U.S. Treasury yield forecast1H26 at 3.85%, YE26 at 3.90%Result of Fed hawkishness and labor market improvement, slightly higher vs. early May's 3.89%
• 10-year U.S. Treasury yield forecast1H26 at 4.40%, YE26 at 4.50%Driven by term premium and real rate increases, consistent with pre-conflict highs
• Fed benchmark rate forecast3.5%-3.75% hold for full year, possible hike in 3Q27Assumes labor market tightens, inflation stays above 2%; current rates sufficiently restrictive
• Oil price forecast2026 average at $97/barrel, mostly in low $100 rangeAssumes Strait of Hormuz reopens early June; sustained closure/ escalation poses upside risks
• U.S. GDP growth forecast2026 q4/q4 YoY at 1.7%Moderate growth, reflecting energy shock drag
• U.S. unemployment forecast4Q26 at 4.2% (annualized)Gradual rise from current 3.9%, reflecting labor market resilience
• Core PCE inflation forecast2026 q4/q4 YoY at 3.1%Remains above Fed's 2% target, maintaining inflation stickiness
• USD/JPY year-end target164Current intervention line at 160; report sees 140 as unsustainable against medium-term depreciation
• EUR/USD forecast2Q26 at 1.17, 3Q+ at 1.20Weak European growth and unresolved energy dependence limit EUR appeal
• Global U.S. spot LNG flowsAsia destinations >200 Mcm/day, first since summer 2024Reflects JKM premium over TTF, favoring Asian economics
• Nickel C1 cost boundary riseIndonesian quota cuts, sulfur price spikesBiggest cost shock for HPAL producers (>10% global capacity), raising marginal costs
• Global urea capacity losses>2.5 million tons since Middle East conflictConcentrated in Qatar, India, Bangladesh; Europe and U.S. have locked in seasonal needs
• OECD private sector net borrowing2026 at $2.252 trillion, T-bills at $76.1 billionIncludes $49 billion secondary market purchases, signaling ongoing pressure
• U.S. fiscal deficit forecastFY2026 at $1.98 trillion, FY2027 at $2.0 trillionPersistent high deficits add Treasury supply pressure, supporting spread widening
• Fed Chair reappointment probabilityPredictive markets imply 80% chance pre-end of term (mid-May)DOJ closing Fed HQ cost overrun investigation boosted odds
• EM ex-China swap rates2y/5y/10y average only 36% below peaksOil rebound pressures EM rates; stagflation threats not fully priced
• EMBIGD credit spreadsCurrently 242bp, near 13-year lowsPeaked 40bp wider on March 31, rapid tightening risks excessive optimism

Impact & implications

The report has multiple implications for global asset allocation. First, upward rate bias (vs. early May) suggests bond investors hedge further yield rises, but current levels don't justify pure shorts—derivatives offer better value. Second, sustained high oil prices imply energy cost pressures through 2026, boosting inflation stickiness, limiting Fed cuts but also recession risks. Third, FX uncertainties (Middle East, U.S. short rates, global growth) complicate directional calls, but carry trades remain attractive. Fourth, EM stagflation risks and valuations reduce appeal, but modest overweight is maintained, favoring high-yield oil exporters over importers. Fifth, credit resilience-fundamentals divergence suggests delayed pricing—buying EM CDS hedges is prudent. Finally, Middle East conflicts may widen global deficits, persistently lifting term premia and supporting higher long-end yields.

Risks

• Tail risk of Middle East escalation with prolonged Hormuz closure; sustained closure could push oil above $100/barrel, raising inflation and recession risks
• Aggressive Fed liquidity shocks during Chair transition may spike volatility and hurt risk assets; balance sheet expansion near $1 trillion needed to support 25bp cuts
• EM stagflation risks: Higher oil prices and limited Fed real rate declines may pressure EM growth and inflation simultaneously
• U.S. Treasury supply shocks: FY27+ funding gaps may lift term premia and deter price-sensitive buyers, pressuring long-end yields
• Foreign demand erosion: Private foreign appetite for USTs may weaken due to yield and FX risks, with uncertain official demand offset
• Key reversal risk: Middle East peace and quick Hormuz reopening could trigger 10-15bp yield drops
• CNY appreciation risk: Reduced depreciation pressure and policy resistance may surprise USD/CNH shorts

What to watch

• Middle East developments and Hormuz reopening: Any durable negotiation or partial reopening news will directly impact oil and global rates
• Fed hawkishness persistence: Sticky inflation or tighter labor markets may reprice 3Q27 hike expectations
• UST supply-demand balance: Watch foreign buying, bank demand, MMF flows, and Fed eSLR rules
• Fed Chair confirmation progress: Smooth progress may signal more hawkish policy, affecting USD and long-end rates
• EM fundamental data: Inflation stickiness, current account deterioration, and central bank responses will gauge stagflation risks
• Bank UST allocations: Current attractiveness supports demand, but recession signals could reverse flows
• European growth and fiscal responses: Weak soft data may prompt fiscal expansion, worsening EUR/USD outlook
• Asian FX intervention: U.S.-China summits, Japan policy signals may alter market views on intervention intensity