Written by: Yang Dapan, Jinshi Data

This week, some of 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 inflation risk shocks triggered by war.

The Federal Reserve, European Central Bank, as well as the central banks of Japan, the UK, and Canada will hold interest rate decisions this week. This creates an extremely rare week: all central banks of the Group of Seven (G7) converge to collectively decide on monetary policy that occupies half of the global economy.

Although investors expect them to remain idle, the markets will be on high alert for various signals to see if officials, including Federal Reserve Chair Powell and ECB President Lagarde, express concerns about the inflation threat posed by unprecedented oil supply disruptions caused by the US-Iran conflict.

Such signs of concern and speculation about policies remaining tight or even tightening further in the coming months may negatively impact government bonds. In recent weeks, as traders selectively ignored the impact of war, pushing up the stock and credit markets, the performance of government bonds has lagged behind other assets.

With the Bank of Japan meeting on Tuesday, the Bank of Canada scheduled to meet on Wednesday, and the Federal Reserve, European Central Bank, and Bank of England making appearances on Thursday, Amy Xie Patrick is among the investors bracing for a busy week. She helps manage a dynamic yield strategy at Pendal Group that has outperformed 91% of competing peers over the past five years.

「What do current central bank officials have to lose by issuing some hawkish rhetoric?」 Xie Patrick said, noting that she has liquidated all duration exposure this month. 「There is currently an oil shock, and the inflation outlook is murky. Bonds were supposed to follow the reversal we see in the stock market, but yields are firmly stuck until the situation becomes clearer.」

Government Bond Yields Remain High

Despite some major assets being repriced to pre-war levels or even higher, short-term government bond yields from the US to the UK remain elevated.

Traders attempting to profit from bond volatility have also been left disappointed. So far this month, the daily average movement of yields on one- to three-year government bonds has been only about two basis points, down from four basis points in March.

Stephen Miller, who previously served as head of fixed income at BlackRock in Australia, stated, this situation may change.

Central bank officials are on high alert for another round of price pressures, fearing a repeat of the erroneous judgment made during the pandemic that "inflation is transitory," during which many were caught off guard by the stubbornness of inflation. This lesson is likely to keep decision-makers cautious, even as concerns about economic growth intensify.

Miller, now a consultant at GSFM, pointed out: 「The language from central banks may just poke the hornet's nest of the bond market, pushing bond yields higher. Bond traders may be surprised by the degree of concern central banks express about inflation.」

Taking the UK as an example, Bank of England officials indicated that the war will further worsen prices. Dragged down by sharply rising automotive fuel prices, the country's consumer price index (CPI) rose by 3.3% year-on-year in March, up from 3% the previous month.

As a result, during last week’s trading, the money market’s expectations for rate hikes this year have shifted from just one hike to at least two hikes.

As for the US, Federal Reserve officials have warned that the conflict may exacerbate inflation further, even forcing them to reconsider rate hikes; at the same time, they emphasized that it remains uncertain how long oil prices will linger at high levels.

Amid headlines about the US and Iran flooding the news, the overall macro backdrop makes it difficult for bond investors to price strong expectations for rate cuts later this year until clarity on the oil price shock situation is achieved. However, employment and retail sales data remain robust, suggesting the economy is still resilient.

Short-term US Treasury yields, which are most sensitive to changes in monetary policy, fell last Friday because the US Department of Justice dropped its investigation into the Federal Reserve, potentially paving the way for President Trump’s favored candidate Kevin Warsh to succeed Federal Reserve Chair and push for rate cuts.

US Treasury yields have been confined to a narrow range, oscillating back and forth. Over the past week or so, the market's expectations for rate cuts by the Federal Reserve by the end of the year have fluctuated between 25% and 60%.

TD Securities' US interest rate strategist Molly Brooks anticipates that Powell will display "a neutral stance as the situation in the Middle East remains uncertain in its future impact." She believes that the Federal Reserve will acknowledge in its statement "the recent inflation increase caused by the oil shock," while also pointing out that "underlying inflation has only risen slightly."

Brooks stated that TD Securities expects that given the uncertainty ahead and the Federal Reserve's lack of forward guidance, the 10-year US Treasury yield will "continue to trade in the range of 4.1% to 4.4%."

In other regions, Bank of Japan Governor Kazuo Ueda has emphasized the need to comprehensively assess the upside and downside risks of underlying inflation. Evercore ISI's strategists predict that the Bank of Japan will attempt to present a "hawkish hold" stance to pave the way for rate hikes in June and December.

European Central Bank President Lagarde emphasized the rising uncertainties in a recent speech, and she is likely to reiterate this message at Thursday's meeting. According to swap pricing, the market believes that a rate hike in June is nearly a done deal, with another hike expected by September.

While feeling anxious about short-term inflation, if soaring prices and geopolitical pressures start to erode demand, markets and central banks may ultimately have to shift their focus to concerns about economic growth. This shift in focus could ultimately lower borrowing costs for both officials and markets. Wee Khoon Chong, senior market strategist at BNY Mellon in the Asia-Pacific region, stated:

「Markets will closely look for hawkish signals to maintain current expectations for rate hikes in the Eurozone, UK, Canada, and Japan, as geopolitical uncertainty and persistently high oil and petrochemical product prices pose risks for both upward inflation and downward economic growth. Central banks are likely to convey a cautious hawkish tone but will make no commitments to future rate actions.」

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