Citadel Securities says the big risk to markets is shifting from inflation to a global growth slowdown

• A Citadel Securities strategist has shifted focus to growth risks amid the Iran war.
• The longer the Strait of Hormuz stays closed, the larger the risk of a slowdown, the firm said.
• Investors have priced in inflation risks, but might not be factoring in the hit to growth, the firm said.

Inflation has been top of mind for investors amid surging oil prices, but Citadel Securities says it might be mostly priced in by now, while the risks to growth might still be underappreciated by markets.

The firm turned more upbeat on Treasurys after the latest war-fueled rout. The 10-year Treasury yield edged lower on Tuesday, but is still up 24 basis points since the Iran war began. The rise has been driven by concerns that inflation could see a resurgence and keep interest rates elevated.

But Citidal Securities' macro strategist Frank Flight said on Monday that inflation isn't the biggest risk as the war drags on through the its third week.

"Markets need to see safe passage of international ships through the Strait of Hormuz soon, or financial conditions will need to shift focus from inflation to growth risks," Flight said. "We think there maybe scope for global front end rates to rally and are turning neutral on US fixed income having held a short bias for some time."

Interest rates, both long- and short-term, tend to rise when the threat of inflation increases. But when economic growth prospects begin to sour, they tend to move lower as central banks try to stimulate economic activity and and cut rates, while investors may also pile into bonds seeking shelter while other assets like equities are rattled by weaker growth.

Investors are already pricing in the inflation risk from higher oil prices, however, Flight said. What they're not taking into account is the downside risk to growth that would emerge if the Strait of Hormuz stays closed for an extended period.

That leaves room for downside in stocks, he said, and for corporate bonds to become more expensive relative to Treasurys.

"Markets do not appear to be discounting much downside risk in cross-asset growth pricing," Flight wrote. "If markets begin to price a more drawn-out conflict in which the Strait remains closed, we would expect equities and credit to move materially lower and wider as demand destruction emerges in response to expectations of a more prolonged disruption to global oil and trade flows."

Flight warned that a repricing of growth risks could trigger slower growth by tightening financial conditions, in a kind of self-fulfilling prophecy. This would be exacerbated by the fact that governments are less willing to stimulate their economies through fiscal measures after the 2022 inflation wave.

Citadel Securities' models illustrate Flight's argument. The firm's central bank policy model has shot more than two standard deviations above normal levels into tightening territory, which Flight said signals that investors' expectations for higher rates should soon ease.

The growth model, however, shows that investor expectations have effectively stayed the same since the start of the war, meaning there's more room for downside.

"The growth factor sitting close to unchanged levels suggests a concerning degree of complacency and implies downside risk to equities and credit should the market grow concerned about a more protracted conflict and closure of the Strait," Flight wrote.

Earlier this week, Bank of America also issued a note of caution that investors are not pricing in a potential growth slowdown, as consumers could see energy prices eat into spending budgets, and global economies could have less oil to fuel activity.

"The major risk to markets, beyond shipping, remains the possibility of permanent losses of energy production in the Gulf depending on the degree of Iranian retaliation," the bank said in a client note.