The FTSE 100 rallied sharply on Tuesday, gaining 2.3% as the sudden collapse in crude oil prices erased the geopolitical risk premium that had been priced in since the Iran conflict escalation. Brent crude plummeted over 8% to $72 a barrel, its lowest in three months, after reports of a ceasefire breakthrough in the Middle East. The index, heavily weighted with energy and mining stocks, initially fell on the oil slump but reversed course as investors cheered the broader economic implications.
The trigger was a diplomatic communique suggesting that Iran and its adversaries are close to de-escalating hostilities. Traders, who had been paying a $5 to $7 war premium per barrel, rapidly unwound those positions. The market’s reaction is a classic case of the fear trade reversing. For months, the oil price was artificially inflated by the threat of supply disruptions through the Strait of Hormuz. Now that the risk has ebbed, the deflationary effect is being welcomed by central banks.
The Bank of England, which has been wrestling with sticky inflation, must be breathing a sigh of relief. Lower oil prices directly reduce transportation and manufacturing costs, taking the sting out of the inflation tail. This gives the Monetary Policy Committee more room to hold rates steady, or even cut if the economy weakens further. The gilt market responded with a rally, pushing the 10-year yield down 12 basis points to 4.12%. The yield curve steepened, reflecting a less hawkish outlook.
But let’s not pop the champagne just yet. The FTSE 100’s surge is also a story of capital flight from commodities into equities. The index is a haven for global investors seeking safety in UK blue chips, especially with the pound under pressure. Sterling slipped 0.5% against the dollar, as the oil collapse weighed on the currency. A weaker pound is a double-edged sword: it boosts the earnings of FTSE 100 multinationals but stokes import price inflation.
I remain sceptical that this is a lasting pivot. The Iran situation is volatile, and a ceasefire could unravel overnight. Moreover, the underlying demand picture for oil is weak, with Chinese growth faltering and European industrial production in the doldrums. The true floor for oil may be lower than current levels, which could further shake energy stocks. BP and Shell, which both fell over 3% today, may be the canaries in the coal mine.
For the purposes of our fiscal obsession, the real story is the market’s signalling of reduced inflation expectations. If the oil price collapse is sustained, it could allow the Chancellor to borrow more cheaply and fund spending without spooking bond vigilantes. But history suggests that such windfalls are quickly spent, and the discipline of the market is soon forgotten. The FTSE 100 rally is a welcome respite, but the long-term trend of volatility remains. Watch the VIX, which eased to 18, but is still above its historical average.
In summary, today’s surge is a textbook repricing of geopolitical risk. The war premium has evaporated, and markets are celebrating lower inflation and looser monetary policy. But the hangover may come when we realise that the underlying economy is still struggling to find its footing.
