Prepare for a turn in the interest rate cycle

FOR much of the past year, markets were looking forward to global rate cuts, supported by resilient growth and gradually easing inflation.

At the time, rate cuts were generally not in question. The debate instead centred on the timing and magnitude of rate cuts.

The Middle East conflict has fundamentally altered this narrative. Energy prices have surged, and the impact is already evident in global inflation data.

Year-on-year headline consumer price index inflation rose across many major economies in March, largely because energy contributed more to inflation than it did in February.

Month-on-month data shows the shift even more clearly, with energy CPI inflation rising sharply from February to March across multiple economies.

Eyes on inflation

The inflationary effects of the conflict are likely to become more visible in the coming months.

Higher oil and fuel prices could initially pass through to segments such as transport (especially airfares), electricity and utilities, where energy is either a direct input or a major operating cost.

Second-round effects could then be broader. Food inflation may come under pressure if disruptions around the Strait of Hormuz affect fertiliser exports from Gulf nations.

Higher fuel prices could also raise shipping, logistics and production costs, eventually feeding into goods prices.

The shift is also evident in inflation expectations. Market-based measures, such as inflation break-evens (the difference between nominal and inflation-linked bond yields), have risen since the outbreak of the conflict.

This is apparent across both shorter tenors, such as two-year break-evens, and longer tenors (10-year break-evens) in several major economies.

Survey-based inflation expectations have also remained elevated, raising the risk that inflation expectations become less anchored to central bank targets.

For central banks, the key risk is that the inflation shock proves more persistent than expected.

There is significant uncertainty on the timing and extent to which inflationary effects appear in economic data, especially given the mix of first-order and second-order channels.

Cutting rates prematurely could therefore reignite inflationary pressures.

Policymakers such as the US Federal Reserve, which had not yet returned inflation to its 2 per cent target, are less likely to “look through” an energy shock this time.

Differing inflation impacts

To be clear, the inflationary impact will differ across economies, depending on domestic inflation conditions, energy-import reliance and the composition of each country’s inflation basket.

Energy-importing economies could face a larger initial inflation shock, especially where fuel-related costs make up a more meaningful share of household spending.

In contrast, economies with stronger domestic demand before the conflict may face a more persistent inflation problem if external price shocks combine with existing pressures, including wage growth and services inflation.

Consequently, while we are preparing for global interest rate hikes, we also expect some divergence between central banks in the timing and pace of tightening.

The Reserve Bank of Australia (RBA) is an example of an early hiker, having already raised rates twice in March and May.

The RBA stated that the conflict had introduced new upside risks to inflation at a time when inflation was already “too high”. This suggests that other central banks facing more immediate inflation pressures may also act quickly.

Meanwhile, the Bank of England and European Central Bank may face pressure to tighten sooner, given their traditionally heavy reliance on imported energy.

In contrast, the Fed may have more breathing room as the US is a net energy exporter. Still, American consumers are already seeing higher prices at the pump, and inflation risks remain clearly tilted to the upside.

The Fed may not ultimately hike as aggressively as its European peers, but we expect it to maintain a hawkish stance throughout the rest of 2026.

Mind the duration exposure

Given the inflation and rates outlook, bond investors should be mindful of excessive duration exposure within their portfolios.

Duration measures a bond’s sensitivity to changes in yields. Longer-duration bonds can see sharper price gains (falls) even for small rate increases (decreases) in yields.

With inflation risks skewed to the upside and the interest rate cycle turning, the risk-reward profile has become more asymmetric, especially for longer-duration bonds.

To us, short to medium-duration bonds generally offer a better balance between stability and yield.

Short-term fixed income, including cash-like solutions, can provide reasonable yields with low sensitivity to interest rate fluctuations.

Within the US dollar space, indicative yields sit around the high-3 to low-4 per cent range for relatively low levels of risk, making this segment useful for investors seeking yields and capital stability.

Medium-term fixed income can provide some yield pickup over short-term bonds, particularly where the yield curve remains upward-sloping. This yield pickup is more pronounced in corporate bonds than in sovereigns.

We continue to find many opportunities among high-quality companies with visible cash flows and manageable refinancing needs.

While bond prices may fluctuate along the way, buy-and-hold investors may be able to lock in yields of more than 4 per cent in the US dollar corporate bond space today.

Long-term bonds are more vulnerable to upward shifts in yields, especially if rate hikes materialise, long-term inflation expectations reprice higher, and/or fiscal concerns intensify in specific economies.

There may still be tactical opportunities here, but investors should have a clear entry and exit plan in mind before investing here.

A turn in the global interest rate cycle is coming. Central banks are likely to pivot towards a more hawkish direction, as the Middle East conflict adds significant upside risks to inflation.

In this environment, investors should favour high-quality issuers, keep portfolio duration exposure measured, and stay nimble as the interest rate outlook evolves.

The writer is a senior analyst in the global fixed income team at FSM Global, the B2C division of iFast Financial