Do the fixed income markets remain bearish?

Major G10 central banks have been reticent to respond quickly to the conflict in Iran. That’s understandable given the chaotic geopolitics that underlies the war. But the danger is that delay allows inflation to take a grip and keeps government bonds on the defensive. While inflation created by an energy price shock should prove transitory, the Fed, for one, got into difficulties before in 2021 by describing a rise in inflation as transitory when it actually turned out to be pretty insidious.

Higher energy prices were also a big part of that ‘miss’ by the Fed—and other central banks—and they will be hoping that lightning does not strike twice. Admittedly, the 2021/22 inflation episode was just as much about the post-Covid mismatch between demand and supply across many products and services, something that is not so much in play now. But supply pressures could easily develop again, especially if the war drags on and opening the Straits of Hormuz proves difficult.

A second issue to bear in mind is that the 2021/22 surge in inflation across the world was the first for many decades. But now it is fresh in consumers’ minds, and that could easily inflame wage demands should consumers fear that a second affordability crisis is coming thanks to the war in Iran. In short, Steven Barrow, Head Strategist of the Standard Bank, has its doubts that longer-term inflation expectations are as well anchored as central bankers would like us to believe.

On this score, it is notable that some central banks, such as the ECB and BoE have raised the possibility that rates could be hiked to see off the inflation threat, while there have been no such hints from the Fed. Now clearly Europe faces a bigger threat from the energy crisis given that it is not self-sufficient in energy provision, unlike the US.

In addition to this, the Fed works on the basis of its dual (inflation and employment) mandate, and it is clear that the full-employment side of the mandate is also at risk of being missed. So, there are reasons for the Fed’s relative dovishness, but this does have consequences for longer-term inflation expectations. The ECB’s apparent willingness to entertain the idea of quick-fire rate hikes has kept longer-term inflation expectations quite stable. Here we judge expectations by using the five-year forward starting five-year inflation swap, a favorite of the ECB.

In contrast, the Fed’s relative dovishness has had a cost in terms of rising long-term inflation expectations since the start of the war. If we add to this other costs from the war, such as the impact on the US budget and the reputational hit for the Administration, we think it leaves treasuries as the notable underperformer compared to EGBs, notwithstanding the safe-asset qualities that treasuries are supposed to have.

Steven Barrow feels that the Fed is most likely to leave rates unchanged all year before making modest rate cuts next year as the adverse growth implications start to take over from higher inflation as the focus of all central banks. The same considerations could mean that the ECB and BoE follow similar paths, with rate stability this year and cuts, either very late this year or in 2027. However, with no end in sight to the conflict in Iran, or the rise in energy prices, and with more inflationary pressure likely from food prices, we see a (slightly) greater than 50% probability of the ECB and BoE hiking rates once, if not twice in 2026.

“A number of other G10 central banks that face the same adverse inflation/growth trade-off also seem likely to prioritise inflation and lift rates. Here we would note the reserve banks in Australia and New Zealand, while the Bank of Japan seems likely to push on with rate hikes as well even if the closure of Hormuz Staits to oil traffic causes Japan more problems than most. In all, should most G10 central banks push monetary policy in a more hawkish direction; while leaving the Fed behind, the cost could be treasury underperformance”, said Steven Barrow.