Global bonds slide as failure of talks adds to inflation fears

[NEW YORK] The failure of peace talks between the US and Iran is further shifting the bond market’s focus to inflation and reinforcing expectations that interest rates will stay higher for longer.

Risk that higher energy costs will add to already elevated price pressures, delaying US Federal Reserve interest-rate cuts, is front of mind for investors in the US$31 trillion Treasuries complex. Traders and strategists at Pacific Investment Management Company, Brandywine Global Investment Management, and Natixis North America are bracing for yields to remain elevated – and many are reluctant to make big shifts in their allocations until there is greater clarity on the inflation outlook.

Friday’s (Apr 10) release of inflation data for March showed consumer prices jumped the most on a monthly basis since 2022. That pushed 10-year Treasury yields above 4.3 per cent and prompted traders to trim bets on rate cuts this year. Yields climbed a further three basis points on Monday (Apr 13) to 4.35 per cent after US President Donald Trump ordered a blockade of the Strait of Hormuz following the collapse of the weekend talks.

“The pendulum does shift back to inflation,” said John Briggs, head of US rates strategy at Natixis. “The jobs market is stable at best and structurally it’s not very dynamic, but for now inflation is on the docket.”

The shift underscores how quickly the market narrative has turned: With oil prices well above pre-conflict levels, inflation is becoming harder to ignore. For many investors, who must also contend with the possibility that a protracted conflict will eventually drag on economic growth, the more immediate question is how long elevated energy costs will continue to feed through to consumer prices.

Japan’s 10-year yields climbed to the highest level since 1997, while similar-maturity yields in Australia and New Zealand both advanced at least six basis points.

The US labour market, meanwhile, remains on solid footing. Payrolls rose in March by the most since late 2024, while the unemployment rate dipped to 4.3 per cent, further complicating the case for imminent easing.

Kevin Flanagan, head of investment strategy at WisdomTree, said it will take “at least three months to see a clean read on inflation”. With inflation still about one percentage point above the Fed’s target and unemployment holding near 4.5 per cent, he added, the central bank “has less urgency to consider rate cuts from here”.

Traders have already adjusted their expectations, pushing back expectations for the next quarter-point Fed cut until mid-2027. Before the war, they had priced two cuts this year. The central bank has kept rates on hold since December, when it lowered the policy range to 3.5 to 3.75 per cent.

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Front end

Lingering questions around the pause in fighting, the status of the Strait of Hormuz and the trajectory of oil prices, meanwhile, are keeping pressure on the front end of the Treasury curve, where expectations for monetary policy remain in flux.

“In some ways, the Fed’s job has been made marginally easier as they can say there is uncertainty about what will happen to inflation over the medium term,” said Andrew Jackson, head of investments at asset manager Vontobel. A Fed “highly likely to pause for longer than previously expected” makes the three- to five-year part of the curve more attractive, he said.

Others are content to stay on the sidelines for now.

“If the ceasefire persists and oil continues to underperform, markets will shift focus back to the labour market,” said Jack McIntyre, portfolio manager at Brandywine Global Investment Management, who remains underweight Treasuries. “If the facts change, we will shift our view pretty quickly.”

The March inflation report showed prices rose 0.9 per cent on the month, driven largely by a spike in petrol, while core prices – which exclude food and energy – came in slightly below forecasts. The increase was broadly in line with expectations, with companies including Delta Air Lines and the US Postal Service already signalling price hikes.

“The Fed would need to see both the spike and a few reports of moderation before it would feel comfortable continuing to cut, in the absence of any growth deterioration,” said Molly Brooks, US rates strategist at TD Securities. “Both of the Fed’s mandates are becoming more equally weighted, though recent labour market prints showed resilience in the labour market.”

Minutes from the Fed’s Mar 17 to 18 meeting showed officials saw two-sided risks before the conflict, with the “vast majority” citing both upside risks to inflation and downside risks to employment.

That tension is now being sharpened by the jump in energy prices, which have caused a “supply-side inflationary shock”, said Daniel Ivascyn, chief investment officer at Pimco.

“For the time being, it’s a legitimate market risk that inflation remains elevated and you see weakness more broadly across financial assets,” he said. The firm favours higher-quality bonds while looking to capitalise on any market dislocations.

Amid the shifting outlook for Fed policy, one anchor remains: the 10-year Treasury yield has largely fluctuated between 4 and 4.5 per cent and averaging around 4.25 per cent since mid-2023.

“There’s still a lot of uncertainty, and the 10-year is back in the middle of its long-term range,” WisdomTree’s Flanagan said. BLOOMBERG