Article by: Yang Dapan, Jin10 Data
This week, the world's most important central banks may provide investors with new reasons to sell government bonds, as policymakers find themselves forced to confront the risk of an inflation shock triggered by war.
The Federal Reserve, the European Central Bank, and the central banks of Japan, the United Kingdom, and Canada will all hold interest rate decisions this week. This creates an extremely rare week: all G7 central banks convene simultaneously, jointly shaping monetary policy that accounts for half of the global economy.
Although investors expect them all to hold steady, markets will be highly vigilant for any signals, watching whether officials, including Fed Chair Jerome Powell and ECB President Christine Lagarde, are concerned about the inflation threat posed by an unprecedented disruption to oil supply triggered by the US-Iran conflict.
Any signs of such concern, as well as speculation that policy will remain tight or even become tighter in the coming months, could negatively impact government bonds. In recent weeks, government bonds have underperformed other assets as traders selectively ignored the impact of the war, driving up stock and credit markets.
With the Bank of Japan meeting on Tuesday, the Bank of Canada scheduled for Wednesday, and the Fed, ECB, and Bank of England taking the stage on Thursday, Amy Xie Patrick is one of those investors bracing for a busy week. She helps manage a dynamic income strategy at Pendal Group that has outperformed 91% of its peers over the past five years.
"What do central bankers have to lose by making some hawkish comments now?" said Xie Patrick, who cleared all duration exposure this month. "There's an oil shock, and the inflation outlook is murky. Bonds wanted to follow the reversal we saw in equities, but yields are stuck in place," until the situation becomes clearer.
Treasury Yields Remain Elevated
Although some major assets have re-priced to pre-war levels or even higher, short-term government bond yields from the US to the UK remain elevated.
Traders trying to profit from bond volatility have also been disappointed. So far this month, the average daily move in one-to-three-year government bond yields has been only about two basis points, down from four basis points in March.
Stephen Miller, a former fixed income head at BlackRock in Australia, said this situation could change.
Central bankers are wary of renewed price pressures, fearing a repeat of the pandemic-era misstep of labeling inflation "transitory," which left many blindsided by its persistence. That lesson is likely to keep policymakers cautious, even as concerns about economic growth mount.
"The central bank rhetoric might be just enough to poke the hornet's nest in the bond market, pushing yields higher," said Miller, now a consultant at GSFM. "Bond traders might be surprised by how hawkish central banks sound on inflation."
In the UK, for example, Bank of England officials have indicated the war will worsen price pressures. Dragged down by a sharp surge in motor fuel prices, the country's Consumer Price Index (CPI) rose 3.3% year-on-year in March, up from 3% in the previous month.
As a result, during last week's trading, money markets' expectations for rate hikes this year shifted from just one hike to at least two.
As for the US, Fed officials have warned that the conflict could further fuel inflation and even force them to reconsider rate hikes; they have also emphasized the high uncertainty over how long oil prices will remain elevated.
Amid constant headlines regarding the US and Iran, the overall macro backdrop makes it difficult for bond investors to price in strong expectations for rate cuts later this year until the situation regarding the oil shock becomes clearer. However, employment and retail sales data remain strong, suggesting the economy is still resilient.
Short-term US Treasury yields, most sensitive to monetary policy changes, fell on Friday after the US Department of Justice dropped its investigation into the Federal Reserve, potentially clearing the way for President Trump's favored candidate, Kevin Warsh, to take over as Fed Chair and push for rate cuts.
US Treasury yields have been oscillating within a narrow range. Over the past week or so, market expectations for the probability of a Fed rate cut by year-end have swung between 25% and 60%.
Molly Brooks, US rates strategist at TD Securities, expects Powell to strike a "neutral stance, given the uncertainty surrounding the future impact of the Middle East situation." She believes the Fed will acknowledge in its statement "a recent uptick in inflation due to the oil shock," while also noting that "underlying inflation has only risen slightly."
Brooks said TD Securities expects the 10-year Treasury yield to "continue trading in the 4.1% to 4.4% range," given the future uncertainty and lack of forward guidance from the Fed.
Elsewhere, Bank of Japan Governor Kazuo Ueda has consistently emphasized the need for a comprehensive assessment of both upside and downside risks to underlying inflation. Strategists at Evercore ISI predict the BOJ will attempt to present a "hawkish hold," paving the way for rate hikes in June and December.
ECB President Christine Lagarde also highlighted rising uncertainty in a recent speech, and she is likely to reiterate this message at Thursday's meeting. According to swap pricing, the market sees a June rate hike as nearly certain, with another hike expected by September.
While anxious about near-term inflation, markets and central banks may eventually be forced to pivot towards concerns about economic growth if rising prices and geopolitical pressures begin to erode demand. Such a shift in focus could ultimately lower official and market borrowing costs. Wee Khoon Chong, Senior Market Strategist for Asia Pacific at BNY, said:
"Markets will be closely looking for hawkish signals to maintain current expectations for rate hikes in the Eurozone, UK, Canada, and Japan. Geopolitical uncertainty and persistently high oil and petrochemical prices pose both upside risks to inflation and downside risks to economic growth. Central banks are likely to convey a cautiously hawkish tone but make no commitment on future rate moves."
