The world’s most important central banks will potentially hand investors fresh reasons to sell government bonds this week as policymakers find themselves forced to confront the risk of a war-driven inflation shock.
The Federal Reserve, European Central Bank and peers in Japan, the UK and Canada are all scheduled to set interest rates. That makes for a rare week in which every Group of Seven central bank convenes, together deciding monetary policy for about half the world’s economy.
While investors expect them to all leave rates unchanged, markets will be alert to signs officials, including Fed Chair Jerome Powell and ECB President Christine Lagarde, are worried about the inflation threat posed by the biggest disruption to oil supply in history stemming from the US-Iran conflict.
Indications of concern and speculation that means tight or even tighter policy in coming months would likely be negative for government debt, which has already underperformed other assets in recent weeks as stocks and credit markets rallied with traders looking past the war.
Bonds started the week on a soft note across the US, Europe and Japan. The 10-year Treasury yield rose two basis points to 4.32%, with the equivalent German rate rising by a similar margin.
With the Bank of Japan meeting on Tuesday, the Fed and Bank of Canada on Wednesday and the ECB and Bank of England on Thursday, Amy Xie Patrick is among the investors bracing for a busy week. She helps run a dynamic income strategy at Pendal Group that’s beaten 91% of peers in the past five years.
“What have central bankers got to lose sounding hawkish now?” said Xie Patrick, who has exited all her duration exposure this month. “There’s the oil shock. There’s the uncertain picture of inflation. Bonds want to follow the reversal we’ve seen in equities, but yields are so stuck” until there’s further clarity.
Although some major assets have re-priced to pre-war levels or even higher, shorter-dated yields from the US to the UK remain elevated.
Traders looking to profit from bond volatility have also been left largely disappointed. Yields on one- to three-year government notes have averaged a daily change of about two basis points so far this month, down from four basis points in March.
This could potentially change next week, said Stephen Miller, the former head of fixed-income at BlackRock Inc. in Australia.
Central bankers are on guard for renewed price pressures, wary of repeating the “transitory” misstep of the pandemic when many were surprised by the stubbornness of inflation. That experience is likely to keep policymakers cautious, even as growth concerns mount.
“Central bank rhetoric may just poke the bond bear and drive bond yields higher,” said Miller, consultant at GSFM. “Bond traders may well be surprised with the intensity of the focus on inflation.”
Take the UK, where BOE officials say the war will worsen prices. The consumer prices index rose 3.3% from a year earlier in March, up from 3% the previous month, reflecting a sharp jump in the price of motor fuel.
In turn, over the course of last week, money markets went from pricing just one hike this year to at least two increases.
As for the US, Fed officials have warned the conflict could further stoke inflation and even force consideration of hikes, while also stressing uncertainty over how long oil prices stay elevated.
Amid conflicting headlines from the US and Iran, the overall macro backdrop leaves bond investors struggling to price in a strong chance of rate cuts later this year, until clarity from the oil price shock emerges. Still, employment and retail sales continue to hold up, suggesting economic resilience.
Short-term Treasury yields, the most sensitive to monetary policy changes, fell on Friday after the Justice Department dropped its investigation into the central bank, potentially opening a path for President Donald Trump’s pick, Kevin Warsh, to become Fed chair and push for rate cuts.
Yields on Treasuries have been confined to narrow ranges with expectations for a Fed rate cut by the end of the year swinging between a roughly 25% to 60% chance over the past week or so.
Molly Brooks, US rates strategist at TD Securities USA LLC, expects Powell to project “a neutral stance given the uncertainty of the future impacts coming from the Middle East,” with the central bank acknowledging in its statement that the “recent uptick in inflation due to the oil shock,” while also noting “that underlying inflation is only somewhat elevated.”
TD expects the 10-year will “continue to trade in the 4.1% - 4.4% range, given the uncertainty going forward and a lack of forward guidance coming from the Fed,” said Brooks.
Elsewhere, BOJ Governor Kazuo Ueda has emphasized the need to assess both upside and downside risks to underlying inflation. Strategists at Evercore ISI predict the BOJ will try to deliver a “hawkish hold” that paves the way to hikes in June and December.
The ECB’s Lagarde has also stressed the elevated uncertainties in a recent speech, a message she’s likely to reiterate on Thursday. Markets see a hike in June as all but certain, based on swaps pricing, with another coming by September.
At the same time as they fret about inflation in the near-term, markets and central banks may ultimately need to pivot to worrying about growth if costlier prices and geopolitical stresses start hurting demand. Such a shift would likely end up weighing on official and market borrowing costs.
“Markets will be looking for hawkish signals to sustain current rate hikes expectations in Eurozone, UK, Canada and Japan,” said Wee Khoon Chong, senior APAC market strategist at BNY. “Geopolitical uncertainties and elevated oil and petrochemical prices present both upside inflation risk and downside growth risk. Central banks are likely to deliver a cautious hawkish tone but be non-committal to future rate moves.”
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