A Deutsche Bank report highlights four major market contradictions, suggesting the recent equity rally rests on a fragile foundation.
A growing divergence between equities and more risk-sensitive assets like bonds and oil suggests markets are sending deeply contradictory signals about the impact of the ongoing Iran conflict, according to a Deutsche Bank report. The analysis by macro strategist Henry Allen, published May 7, identifies four significant dislocations where asset classes are telling different stories, indicating a rising risk of a market correction.
"In the first month of the Iran conflict, there was a tight correlation between different asset classes, with oil, bonds and equities all seeing consistent moves," said Henry Allen, a strategist at Deutsche Bank. "But as his charts show, since mid-April, equities have strongly diverged from oil and rates."
The primary split shows up between stocks and bonds. Since the conflict began, the 10-year U.S. Treasury yield has moved in lockstep with Brent crude oil prices, reflecting a direct pricing of inflation risk from the energy shock. The S&P 500, however, has decoupled from this relationship, climbing back toward all-time highs. This divergence is also visible in Europe, where the STOXX 600 is just 1.7% below its peak, despite the region’s greater exposure to energy shocks.
The core contradiction is that the bond market is pricing in a sustained period of higher inflation and risk, while the equity market appears to be dismissing it as a transient event. According to the report, both cannot be right, suggesting that if the bond market’s assessment proves correct, equities face a sharp downward repricing.
Central Bank and Credit Markets Price in Dissonance
A second major anomaly appears in the market's pricing of central bank policy. Futures markets are currently pricing in almost no action from the U.S. Federal Reserve over the next 12 months, with just two basis points of hikes implied by March 2027. In contrast, the same markets have fully priced in two 25-basis-point hikes from the European Central Bank over the same period, with a one-in-three chance of a third.
This pricing is difficult to justify with economic fundamentals. U.S. core PCE inflation stood at 3.2% in March, while Eurozone core CPI was 2.2% in April. Furthermore, the U.S. economy is growing faster, with recent nonfarm payroll data showing the strongest performance in 15 months. The report notes it is logically inconsistent for markets to price in a hawkish ECB and a paused Fed when U.S. growth and inflation are both higher.
Adding to the puzzle, credit markets have ignored the multiple risk factors. Despite the energy shock, downward revisions to growth forecasts, and a hawkish turn from central banks, both U.S. and European high-yield and investment-grade credit spreads have tightened to levels below where they were before the conflict started. This stands in stark contrast to the spread widening seen during the risk-off environment of 2022.
Is Long-Term Inflation Optimism a Miscalculation?
The fourth and perhaps most significant dislocation is the market’s unwavering confidence in long-term inflation targets. The 5-year/5-year forward inflation swap rate, a key gauge of long-term expectations, hovers around 2.16% for the Eurozone and 2.41% for the U.S., little changed from pre-conflict levels. This indicates investors firmly believe inflation will return to central bank targets.
This optimism faces a challenging reality. U.S. PCE inflation has now been above the Fed’s 2% target for five consecutive years, and the latest energy shock will likely extend that period. From a broader historical perspective, the report points out that since the collapse of the Bretton Woods system in 1971, no country has managed to sustain an average inflation rate below 2% for a prolonged period. This historical context suggests the market's confidence in a swift return to low inflation may be misplaced.
Ultimately, the report concludes that these four contradictory signals cannot logically coexist indefinitely. The divergence between rallying stocks, risk-averse bond markets, tightening credit spreads, and optimistic inflation expectations points to a market that is internally inconsistent, heightening the probability of a correction as these anomalies resolve.
This article is for informational purposes only and does not constitute investment advice.
