Middle East geopolitical risks have further receded, with Iran announcing that the Strait of Hormuz is now "fully open" to commercial shipping. Prior to this development, U.S. stock markets had already staged a significant rebound. As geopolitical risks subside, Goldman Sachs argues that for U.S. equities to maintain their current upward momentum, the Federal Reserve needs to pivot back to an interest rate cutting stance.

Christian Mueller-Glissmann, Head of Asset Allocation Research at Goldman Sachs Group, characterized the recent strong rally in U.S. stocks as a "fast and furious recovery phase." He noted that part of the rebound is technically driven—including hedge funds, which had previously sold stocks to reduce risk, now being forced to rebuild their positions. Although the S&P 500 appears headed for a third consecutive week of gains exceeding 3%, Mueller-Glissmann questions whether this rally is sustainable without support from monetary policy. He pointed out that maintaining the current upward trend in U.S. stocks requires the Fed to shift back towards cutting rates.

In an interview, Mueller-Glissmann stated, "To sustain this recovery and keep the rally going, I think we need the Fed to somewhat return to its previous policy stance. We need to see a relief in interest rate pressure." He also observed that despite the sharp stock market gains, oil prices remain elevated and the credit market is lagging behind equities. He attributed part of the stock market's strong performance to greater exposure to technology stocks, which continue to "deliver solid results."

The Fed's Policy Dilemma Although investors have recently chosen to treat headlines related to the Middle East conflict as market noise and have re-embraced U.S. stocks, led by tech shares, amid a corporate earnings season demonstrating resilience, the conflict's negative impacts on U.S. economic growth and inflation cannot be ignored.

John Williams, Vice Chair of the Federal Reserve and President of the New York Fed, stated on Thursday that the Middle East conflict has begun to materially impact the U.S. economy, manifesting as increased price pressures and slowing economic growth momentum. Addressing bankers in his district, he indicated that the conflict has further heightened uncertainty surrounding the U.S. economic outlook. While he still expects the economy to grow and inflation to gradually decline this year, he acknowledged that the Fed currently faces dual risks of rising inflation and slowing economic growth.

Williams suggested that if energy supply disruptions ease relatively quickly, energy prices should decline, and related impacts could partially reverse later this year. However, he warned that if the conflict escalates into a larger supply shock, it could further increase inflation and suppress economic activity by raising intermediate input costs and commodity prices, a trend that is "already beginning to show."

Alberto Musalem, President of the St. Louis Fed, similarly stated that "supply shocks are threatening the Fed's dual mandate on inflation and employment," noting that "the current interest rate range is likely to remain appropriate for some time." He added, "The oil price shock may be transmitting to core inflation, meaning core inflation could remain close to 3% by the end of this year."

Even Philip Jefferson, a Fed Governor who has consistently supported more significant and frequent rate cuts, has recently moderated his stance. Jefferson said on Thursday that his position on rate cuts has become more restrained because inflation appears more stubborn; he now believes the case for monetary easing is less compelling than before. He initially expected four rate cuts this year but now leans towards three. Jefferson noted that the inflation situation has deteriorated since December, though this isn't solely due to the Middle East war; he had observed this trend months before the conflict erupted. He pointed out that the underlying composition of inflation has become more challenging, with "contributions from some other sectors starting to increase, making the situation more complex than at the start of the year." Jefferson currently believes the Fed should move towards a neutral interest rate, which he estimates to be as low as 2.5%. He expects inflation to reach the Fed's 2% target in about a year. Regarding the labor market, he sees no reason to believe the cooling trend won't persist and, given the labor market's weakness, advocates for rate cuts now.

In summary, the dual risks of rising inflation and slowing economic growth stemming from the Middle East conflict are placing the Fed in a policy dilemma. As of the latest update, the CME FedWatch Tool indicates a 62.9% probability that the Fed will keep the benchmark interest rate unchanged until the end of 2026. At the March 17-18 monetary policy meeting, the Fed announced it would maintain the federal funds rate target range between 3.5% and 3.75%, holding rates steady for the second consecutive meeting. Although projections released after the meeting showed most officials still anticipated at least one rate cut this year, the March meeting minutes revealed growing concerns. Many policymakers emphasized that upside risks to inflation could ultimately necessitate rate hikes. The possibility of inflation remaining above the 2% target for an extended period has increased significantly.

The March minutes showed that a vast majority of participants judged that progress toward the 2% inflation target was slower than previously expected, and the risk of inflation persisting above target had increased. Concurrently, most officials worried that a prolonged conflict could hurt the labor market, potentially requiring rate cuts. Many cautioned that, given the low level of net new job creation, labor market conditions are vulnerable to negative shocks. A protracted Middle East conflict could dampen business sentiment and lead to further contraction in hiring.

Even before the current Middle East conflict erupted, the Fed's room for rate cuts had narrowed—the labor market had stabilized, alleviating recession fears, while the process of inflation falling back to the Fed's 2% target had stalled. Combining signals from the Fed's meeting minutes with current market conditions, the highest probability scenario for the near term is the Fed maintaining rates on hold, with immediate possibilities of either hiking or cutting rates seen as low.

Regarding the threshold for rate hikes, while a few officials are open to the idea, most judged it "premature" to assess the economic impact of the Middle East situation, preferring a cautious, wait-and-see approach. Concerning conditions for rate cuts, the minutes specified a scenario that could trigger further easing: if the Middle East conflict persists and leads to a further deterioration in labor market conditions, it might necessitate accelerating the pace of rate cuts. However, the stronger-than-expected U.S. non-farm payrolls data for March does not align with this scenario, temporarily easing the urgency for near-term Fed rate cuts.

Some analysts suggest the Fed's monetary policy path will largely depend on external variables beyond its control—namely, the duration and intensity of the Middle East conflict. Under these circumstances, the Fed's policy approach is likely to be characterized by "watchfulness—awaiting data—discretionary decision-making." The Fed will announce its next interest rate decision on April 29. This decision will be a key test for the Fed's monetary policy outlook. Markets widely expect the Fed to hold rates steady at that time. Therefore, any changes in wording in the policy statement and comments from Fed Chair Jerome Powell during the press conference will be crucial for markets judging the future path of Fed policy.

Potential Disruption in Fed Leadership Transition Could Thwart Hopes for Rate Cuts Meanwhile, the transition process for the Fed Chair is not proceeding smoothly, which could become a variable influencing the Fed's policy path. The U.S. Senate Banking Committee is expected to hold a confirmation hearing next week for Kevin Warsh, nominated by the former administration for Fed Chair. This hearing will provide a platform for Senators from both parties to scrutinize Warsh's views on the economy and monetary policy. Warsh previously served as a Fed Governor and was an economic policy advisor. Investors are particularly focused on how Warsh might balance competing pressures—on one side, pressure for significantly lower borrowing costs, and on the other, economic conditions that, at least in the short term, do not sufficiently justify rate cuts. Given repeated criticisms of the Fed and inflation having been above the central bank's target for over five years, any misstep in addressing interest rate questions could undermine the credibility of a Fed under Warsh's leadership.

However, even if Warsh's performance at the committee hearing is flawless, his path to Senate confirmation remains uncertain as long as the Justice Department's investigation into current Chair Jerome Powell continues. Republican Senator Thom Tillis has stated he will not support any nominee until the criminal investigation is resolved, believing it threatens Fed independence. The former administration recently reiterated that if Powell does not depart the Fed on schedule, action will be taken to remove him. While Powell's term as Chair ends on May 15, his term as a Board Governor continues until January 2028. Conventionally, an outgoing Chair resigns from the institution completely after their leadership term ends, but Powell stated in March he intends to remain until the Justice Department investigation is resolved "in a transparent and final manner." The former administration has stated it does not intend to drop the investigation into Powell, reiterating the need to probe issues related to Fed building projects. This week's raid by U.S. prosecutors on a construction area at Fed headquarters indicates the Justice Department has not abandoned its investigation, even after a district court judge earlier this month upheld a ruling quashing subpoenas against Powell.

If Warsh is not confirmed by May 15, Powell has indicated he intends to serve as interim Chair and would likely continue in his other key role—Chair of the rate-setting Federal Open Market Committee (FOMC). This means that continued pursuit of the investigation could not only delay Warsh's confirmation but also allow Powell to retain significant control over monetary policy.

Corporate Earnings Resilience is a Key Foundation! Wall Street Bullish on U.S. Stocks Despite the uncertainty surrounding Fed policy, buoyed by resilient corporate earnings, several Wall Street firms have recently voiced strong optimism for U.S. equities, with markets beginning to anticipate a new bull market led by technology stocks.

Tom Lee, a veteran stock market strategist and co-founder of Fundstrat, often referred to as the "Wall Street Soothsayer," believes the U.S. stock market, and global equities broadly, are in a stronger position now than when they hit their previous all-time highs earlier this year. Lee agrees with a typical assessment from financial giant JPMorgan Chase that the technology sector, centered on AI computing infrastructure, will lead the main theme of the next super bull market phase.

Citigroup upgraded its rating on U.S. stocks from "Neutral" to "Overweight" and expects the S&P 500 to reach 7,700 by year-end. The bank's latest research report indicates that the technology sector, previously suppressed by geopolitical conflict, valuation concerns, and high expectations, is entering a window transitioning from a recovery in risk appetite to a reassessment of fundamentals. As Middle East tensions marginally cool, markets have swiftly switched from safe-haven assets back to risk assets, with the S&P 500 and Nasdaq strengthening simultaneously. This suggests capital is beginning to trade again on the "future trajectory of overall earnings growth driven by AI" rather than "current panic." Within this framework, tech stocks, especially large platform companies, are no longer just liquidity-driven crowd favorites but are re-emerging as the core anchor for U.S. stock risk appetite and earnings expectations.

Asset management giant BlackRock's equity strategists have turned "Overweight" on U.S. stocks again. BlackRock highlighted the new U.S. earnings season, asserting that the engine of earnings growth can support the main theme of the U.S. bull market. Strategists wrote, "Even during the geopolitical conflict, corporate earnings expectations continue to rise, largely due to strong AI computing demand driven by AI-related investment themes."

In essence, the narrative for a new U.S. bull market rests on three key pillars: the corporate earnings resilience demonstrated in the latest earnings season, a renewed recovery in risk appetite led by the tech/AI computing theme, and the market's judgment that the Middle East shock will not evolve into a prolonged, 2022-style inflation episode. As long as these three logical pillars hold, U.S. stocks are poised to continue their strength against the backdrop of easing Middle East tensions.