The ongoing conflict in the Middle East continues to impact the markets while inflation expectations are recalibrated.
Read this article to understand:
- The market impact of the military conflict in the Middle East and outlook scenarios
- Expectations for central bank policy rates going forward
- How fixed income sectors have behaved so far
The ongoing conflict in the Middle East has led to a rapid repricing in many fixed income sectors, driven overwhelmingly by a re-assessment of inflation risk and the path for central bank rates.
The de facto closure of the Strait of Hormuz has resulted in soaring energy prices and considerable volatility in oil and gas and any news or announcements from either side in the conflict have the potential to move markets significantly.
The sharpest moves have occurred in short‑dated interest rates, where expectations for central bank policy have shifted meaningfully. The adjustments reflected how quickly markets recalibrated inflation expectations as energy prices surged.
The situation in the markets fluctuates at a rapid pace. At the time of writing, markets are expecting between one to two cuts by the US Federal Reserve (Fed) this year, but between one to two hikes by the European Central Bank (ECB) with no change in the UK bank rate. Next year’s expectations hover around little change in policy rates for the Fed and the ECB and none for the Bank of England.
Despite these front‑end moves, most major developed market yield curves have been broadly stable
Despite these front‑end moves, most major developed market yield curves have been broadly stable or have steepened slightly (with Europe the exception, where curves have flattened). This reflects rising long‑term yields and suggests that investors are building in a higher inflation risk premium and preparing for the possibility that the current price shock proves more persistent.
An early turning point was Qatar’s shutdown of LNG production following Iranian strikes – the first major physical supply disruption of the conflict. At the same time, broader attacks across Gulf energy infrastructure have interrupted roughly one‑fifth of global oil and LNG flows, pushing energy markets into a more stressed environment.
A key factor for the inflation outlook, rates and fixed income markets will be how and whether governments can mitigate this energy-driven inflation pressure.
The US has raised the prospect of naval escorts for commercial shipping and a possible release of Strategic Petroleum Reserves (SPR) should US gasoline prices continue rising. However, these measures are unlikely to offer more than temporary relief if the conflict lasts beyond the next three to four weeks, given the scale of physical disruptions now underway.
Given the scale of the uncertainty, it is unsurprising that investors are now pricing in multi‑week disruption, wider risk premia, and higher expected inflation, alongside a softer outlook for global growth. The US dollar has strengthened, while equity markets have weakened, particularly in energy‑importing regions such as Japan and Europe.
Longer term, the outlook hinges on the length of the conflict and any lasting effect on energy supplies and production.
If the conflict were to de‑escalate quickly, the effect on global growth and inflation may be limited, with markets likely to retrace much of their recent moves. If tensions persist for several more weeks, the most likely outcome is a moderate drag on growth this year and a temporary increase in inflation, as energy‑related pressures feed through. In this environment, central banks may delay – but not abandon – their easing plans, choosing to look through the supply‑driven nature of the shock.
A multi‑month conflict, however, would present the most challenging scenario. Here, global growth could fall by around 0.5 per cent, while inflation remains elevated for longer. Central banks such as the ECB and Bank of England might even feel compelled to tighten further before eventually easing should growth conditions weaken. This would likely weigh on risk assets, reinforcing the importance of quality, diversification and disciplined risk management.
Fixed-income strategy amid uncertainty
In these conditions the appropriate response in fixed-income investment is to be nimble and scenario‑driven and use existing hedges to manage near‑term volatility. It is vitally important to avoid the knee-jerk reaction of de-risking. And there may even be opportunities to add selectively were dislocations overshoot fundamentals.
In these conditions the appropriate response in fixed-income investment is to be nimble
For government bonds the focus on inflation is particularly acute. Demand is so far holding steady for high quality corporate bonds. In the high yield sector, spreads have widened and performance varies, and the key will be selectively focusing on resilient sectors.
The greatest surprise has been in emerging markets, which have remained surprisingly orderly with steady flows, despite the heightened geopolitical tension and sharp moves in global rates.
The last two weeks have been typified by market volatility, which potentially may last for some weeks or even month. As always, the appropriate response is to maintain a long‑term, strategic approach.
