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Thought of the day

Global government bond yields rose at the start of the week after escalating hostilities in the Middle East drove oil prices higher. The US military reported that it had destroyed six Iranian small boats and intercepted Iranian cruise missiles and drones as part of its efforts to open a passage through the Strait of Hormuz.

US Treasury yields rose across the curve on Monday, with the 30-year yield settling above 5% for the first time since July last year, and the 2-year yield moving 7 basis points higher. Benchmark government bond yields in euros and sterling have also risen this week.

Higher-for-longer oil prices and the risk of inflation weighed on sovereign debt, especially after major central banks sounded a hawkish tone last week. Futures pricing now expects no interest rate cuts from the Federal Reserve this year and a 70% probability of a rate hike in 2027. About three 25-basis-point rate hikes are also priced in for the European Central Bank (ECB) and the Bank of England (BoE) over the next 12 months.

But while persistently elevated energy prices remain a significant tail risk, we continue to believe that major central banks are likely to look through supply shocks such as the current spike in oil prices. As long-term inflation expectations remain anchored globally, a repricing of market expectations should lead to declines in government bond yields in the coming months.

The Fed has room to ease further. While three regional Fed presidents voted to remove the easing bias in the central bank’s statement, Chair Jerome Powell said no one on the committee was calling for interest rate hikes. We continue to expect sequential core goods inflation to soften further in the coming months, and our base case calls for lower oil prices toward the end of the year. Oil-related economic headwinds should also slow overall growth in the second half of the year. Additionally, with incoming Chair Kevin Warsh viewing AI as a structurally disinflationary force and favoring a range for the central bank’s inflation target instead of a fixed number, we continue to expect further easing from the Fed later this year.

Growth risks should keep the ECB on hold. We acknowledge the real possibility of near-term rate hikes by the ECB, as the risks of second-round inflation effects increases the longer that the Middle East conflict persists. But growth in the region disappointed in the first quarter, and recent PMI and consumer sentiment surveys suggest that a period of sub-par growth is likely to persist. While President Christine Lagarde said the risks of higher inflation have risen, she also highlighted risks of lower growth. We therefore maintain our expectation that the ECB will keep policy rates on hold through the rest of the year. Even if the governing council does judge that tighter monetary policy is warranted to ward off second-round inflation effects, we do not believe rates will go as high as current pricing implies.

The BoE is also likely to hold rates steady. The BoE similarly noted that inflation risks have risen, and it expects headline inflation to rise further through the year. But the central bank’s analysis also suggests that the risk of persistent second-round effects is modest for now, due to weak demand, a loosening labor market, and a coming squeeze in real income growth. In addition, a meaningful tightening in financial conditions since earlier this year should also weigh on demand. In our view, while mounting inflationary pressures could indeed trigger second-round effects, these will be limited by the dampening effect of the energy shock on growth. We also expect the BoE to keep rates on hold for the remainder of this year.

So, we maintain the view that markets have overpriced the risk that central banks will hike, or not cut, interest rates. This creates an opportunity for investors to “lock in rates” on short- and medium-maturity quality bonds in USD, EUR, and GBP. Those looking to generate additional portfolio income can also consider select exposure to higher-beta segments such as emerging markets, high yield, or subordinated debt, as well as equity income strategies and yield-generating structured investments.