By Douglas Porter

March 6, 2026

To think that just one week ago, the biggest concern for markets was something as humdrum as whether AI was going to take all our jobs and ravage the economy in the years ahead. Those were the good old days.

The conflict with Iran has abruptly changed the economic outlook, with crude oil prices vaulting more than 35% in the past week alone to above $90/barrel for WTI (prices closed at $67 last Friday). The spike has rekindled inflation risks, reduced the odds of central bank rate cuts globally, and is now threatening the global growth outlook. Accordingly, bond yields forged higher across the curve, and equity markets stepped back from the record highs of just last week.

As much as the term ‘stagflation’ has been wildly over-used in recent years, a true oil price shock would indeed increase the risks of stagflationary forces—higher inflation, weaker growth; not a market-friendly combination.

Landing in the middle of this was the February U.S. payroll report, which ratcheted up the ‘weaker growth’ side of the concerns. After a string of generally upbeat indicators for the month earlier on—including both ISM results, auto sales and the ADP jobs release—the reported 92,000 drop in payroll employment was a clear negative surprise.

While the figure was knocked down by a strike among health care workers and by yet another dip in government payrolls, the soft underlying picture washed away the surprising strength in January and left employment barely above year-ago levels (up 0.1% y/y). There was no offset in the household survey, which also reported a February job loss (and a drop in employment of 0.3% y/y), boosting the jobless rate a tick to 4.4%.

The overtly weak jobs report, coupled with a 0.2% drop in January retail sales, leaves the Fed in a challenging spot, with both sides of its mandate now under pressure. Prior to payrolls, the market had spent most of the week dialing back expectations of rate cuts this year as crude climbed steadily higher.

But with the jobs outlook now also in duress, there is still a reasonable chance the Fed will resume rate cuts later on this year—assuming oil prices back down at some point. Still, as of Friday noon, two- and 10-year Treasury yields had climbed 16-18 bps on the week, with five-year yields rising even a bit more (+20 bps).

Meantime, the U.S. dollar strengthened against almost all comers, as it assumed its traditional safe haven status, even with the weakness in the greenback over the past year. The euro fell more than 2% on the week, while the yen weakened 1%. An outlier was the Canadian dollar, which nudged slightly higher, reflecting its status as a significant oil exporter.

The ultimate economic impact of the conflict will depend on how sustained the surge in oil prices proves to be. In our initial analysis of the implications, we weighted four different scenarios for oil prices, two of which saw prices spiking above $100/barrel for a spell. However, our core scenario also looked for prices to back off fairly quickly and to average less than $80 in March, which is now looking on the mild side of reality.

The ultimate economic impact of the conflict will depend on how sustained the surge in oil prices proves to be.

President Trump today posted that there would be no deal with Iran, but only “unconditional surrender”. That seems unlikely anytime soon, and early hopes by the market that the conflict would be short-lived have been promptly quashed. As a result, our overall assumption that average crude prices for 2026 would be up about 15% from pre-war assumptions could also be a bit light.

The one key adjustment we made this week to our forecast was to boost headline U.S. inflation for all of 2026 by 0.3 ppts to 2.7% (with the hit landing heaviest in the next four months). That clearly is at risk of climbing further as oil prices keep ratcheting higher. And while we haven’t cut our U.S. growth outlook yet, a sustained rise in oil prices would eventually carve into consumer confidence and buying power.

Some have suggested that the fact that the U.S. has boosted oil production by 150% in the past 15 years (or by more than 8 million barrels per day to 13.7 million), and is now an oil exporter, shields the economy from a 1970s-style oil shock. That is only partially true, as consumers and businesses still have to pay global prices for energy, and the gains from higher prices are narrowly shared.

The darkening outlook for growth alongside a likely step-up in inflation is a tough combination for equities as well. Investors initially brushed off the conflict, emboldened by prior episodes where geopolitical events made only short-term waves. But the risk from this event is that energy prices don’t revert to norms quickly, and it is becoming increasingly evident that there is a serious risk prices stay elevated for an extended period.

And while all markets took a step back this week, it was notably the Dow and the TSX that got hit the hardest with pullbacks of around 4%. Toronto’s market was also undercut by a 3% drop in gold prices, as bullion faded amid the rebound in the U.S. dollar, revealing what investors regard as the true safe haven during times of stress. Equities were also undercut by the news Friday that Blackrock was limiting withdrawals on its private credit fund, amping up recent concerns around the space.

While the loonie firmed slightly this week, the Canadian economy will face some of the same pressures on both growth and inflation from the oil price spike. The oil-producing provinces of Alberta, Saskatchewan and Newfoundland & Labrador will be shielded, but the rest of the country will be dealing with higher headline inflation and downward pressure on growth.

The key channel is the confidence- and income-sapping rise in pump prices, as well as higher home heating prices. While the energy share of the consumer price basket has waned over the years, it still accounts for almost 6% of the index, with gasoline alone at a 3.2% weight. So, even a temporary 30% jump in energy costs can make big waves on headline inflation. And, unfortunately, investors are gradually coming to the view that the conflict and the upswing in prices may be something more than temporary.

Unlike the Fed, there was little debate over the amount of potential rate cuts by the Bank of Canada—even prior to the spike in oil, the consensus was firmly that there would be no move on rates this year. If anything, the threat of higher inflation has rekindled chatter of a potential rate hike in 2026. We still view that as a very long shot indeed, with the economy struggling to grow, core inflation moving closer to the 2% target, and USMCA uncertainty still clouding the outlook.

Trade talks have finally restarted again after a four-month pause, with Minister LeBlanc visiting Washington on Friday. One optimistic view is that the Iran conflict makes a deal more likely (so the Administration can move it off the ledger), perhaps supported by the recent Supreme Court ruling on emergency tariffs. But given the choppy U.S.-Canada relations over the past 14 months, there are clearly many less favourable possibilities as well. We continue to err on the side of caution on the outlook for USMCA (i.e., prolonged uncertainty) in our Canadian economic forecasts.

Policy Contributing Writer Douglas Porter is Chief Economist for BMO.