"Super Central Bank Week" approaches, as inflation concerns soar, is a market storm unavoidable?

By Yang Dapan, Jin 10 Data

This week, some of the world’s most important central banks may give investors fresh reasons to sell government bonds, because policymakers find themselves forced to face the risk of inflation shocks triggered by war.

The Federal Reserve, the European Central Bank, and the central banks of Japan, the UK, and Canada will all make interest-rate decisions this week. This creates an extremely rare week: all the Group of Seven (G7) central banks are gathered together to jointly decide on monetary policy, which accounts for half of the global economy.

Even though investors expect them to stand pat, the market will be highly alert to all kinds of signals—watching whether officials, including Federal Reserve Chair Jerome Powell and European Central Bank President Christine Lagarde, are worried about inflation threats stemming from unprecedented oil supply disruptions caused by the conflict between Iran and the US.

Signs of such concern, along with speculation that policy will remain tight or even tighten further over the coming months, could weigh on government bonds. In recent weeks, as traders have selectively ignored the impact of the war—pushing up stock markets and the credit market—government bond performance has already lagged behind other assets.

With the Bank of Japan scheduled to hold a meeting on Tuesday, the Bank of Canada set for Wednesday, and the Federal Reserve, the ECB, and the Bank of England stepping in on Thursday, Amy Xie Patrick is one of the investors bracing for a hectic week. At Pendal Group, she helps manage a dynamic income strategy that has beaten 91% of its peers over the past five years.

“Even if current central bank officials put out some hawkish remarks, what would they lose?” Xie Patrick said. “There is currently an oil shock, and the inflation outlook remains murky. Bonds were supposed to follow the reversal we saw in stocks, but yields are being held firmly in place—until the situation becomes clearer.”

Government bond yields remain high

Although some major assets have been repriced to pre-war levels or even higher, short-term government bond yields—from the US to the UK—are still elevated.

Traders hoping to profit from bond volatility are also deeply disappointed. So far this month, the average daily change in yields on one- to three-year government bonds has been only about two basis points, lower than the four basis points seen in March.

Stephen Miller, who previously served as head of fixed income at BlackRock Australia, said this situation could change.

Central bank officials are on guard against fresh rounds of pricing pressure, fearing a repeat of the mistake made during the pandemic when many people believed “inflation is temporary,” only to be caught off guard by how stubborn inflation proved to be. That lesson is likely to keep policymakers cautious, even as worries about economic growth are intensifying.

Miller, who is now an adviser at GSFM, noted: “Central bank wording might just poke a hornet’s nest in the bond market, pushing bond yields higher. Bond traders may be surprised by how strongly the central bank is focused on inflation.”

Taking the UK as an example: UK central bank officials have said that the war will further worsen prices. Dragged down by a sharp surge in automobile fuel prices, the country’s March Consumer Price Index (CPI) rose 3.3% year-on-year, above last month’s 3%.

As a result, in last week’s trading, expectations for this year’s rate hikes shifted from only one hike to at least two hikes.

As for the US, Federal Reserve officials have issued a warning that the conflict could further exacerbate inflation, and even force them to reconsider rate hikes; at the same time, they also emphasized how long oil prices will stay at elevated levels remains uncertain.

As news about the US and Iran continues to dominate headlines, the overall macro backdrop makes it difficult for bond investors to price in strong expectations of rate cuts later this year until the oil-price shock situation becomes clearer. Still, employment and retail sales data remain resilient, indicating that the economy still has staying power.

The short-term US Treasury yields, which are most sensitive to changes in monetary policy, fell last Friday. The reason was that the US Department of Justice dropped its investigation into the Federal Reserve, which may have paved the way for Kevin Warsh—Trump’s favored candidate—to take over as Fed Chair and support rate cuts.

US Treasury yields have been moving back and forth within a narrow range. Over roughly the past week, market expectations for the probability of the Fed cutting rates before the end of the year have been swinging between 25% and 60%.

Molly Brooks, a US rates strategist at TD Securities, expects Powell to adopt a “neutral stance, because the impact of the Middle East situation on the future remains uncertain.” She believes the Fed will acknowledge in its statement “recent inflation increases caused by the oil shock,” while also pointing out that “potential inflation is only slightly higher.”

Brooks said TD Securities expects that, given future uncertainty and the Fed’s lack of forward guidance, the 10-year US Treasury yield will “continue to trade within the 4.1% to 4.4% range.”

In other regions, Bank of Japan Governor Kazuo Ueda has long stressed the need to conduct a comprehensive assessment of the upside and downside risks to potential inflation. Evercore ISI strategists predict that the Bank of Japan will try to present a “hawkish hold” posture, paving the way for rate hikes in June and December.

In a recent speech as well, ECB President Lagarde highlighted rising uncertainty, and she is very likely to reiterate this message at Thursday’s meeting. Based on swap pricing, the market believes a rate hike in June is almost certain, with another hike expected again by September.

While concerns about near-term inflation continue, if increasingly high prices and geopolitical pressure begin to erode demand, markets and major central banks may ultimately have to worry about economic growth. This shift in focus may ultimately lower official and market borrowing costs. Wee Khoon Chong, senior market strategist at BNY Mellon, Asia Pacific, said:

“The market will closely look for hawkish signals to maintain current expectations for rate hikes in the Eurozone, the UK, Canada, and Japan. Geopolitical uncertainty and persistently high oil and petrochemical product prices bring both upside risks to inflation and downside risks to economic growth. The major central banks are likely to communicate a cautious hawkish tone, but they will make no commitment on future rate moves.”