Central banks remain focused on inflation risks

During March, financial markets reacted sharply to the sudden and intense conflict in Iran with spiking oil prices, a correction in stocks, fading Fed easing expectations, and rising US Treasury yields. April has provided some respite, as a ceasefire, on-off negotiations, the continued closure of the Strait of Hormuz, and a US naval blockade of Iranian ports allowed risk assets to rebound sharply while Treasury yields and oil prices remain elevated.

Are Treasury yields in a war rut, stubbornly pricing ongoing energy inflation expectations, or are stocks naively moving on as if the conflict is over? Perhaps neither. More likely, the decline in forward-looking volatility indicators amid rising stock prices and elevated US Treasury yields collectively signal the war will end soon enough to allow a resilient US economy to keep growing. Though stocks rapidly resurged on earnings optimism, bond yields have not returned to their pre-conflict lower levels, primarily because the inflation effect and the Federal Reserve policy implications of lingering high oil prices take time to unfold. The greatest current risk to both stock and bond markets, then, would be a rapid reescalation of the Iran war. Fortunately, a gradual negotiation now seems more likely as the blockade pressures Iran and the ongoing closure of the Strait pressures the Trump Administration, incentivizing each side to negotiate. 

As expected, the Federal Reserve left rates unchanged at the April 29 meeting, restating its ongoing focus on inflation and uncertainties related to the Iran war. Fed Chair Nominee Kevin Warsh likely will take the helm at the Fed in coming weeks now that the Department of Justice investigation of incumbent Fed Chair Powell has ceased and Senator Tillis has signaled his support to proceed with the nomination. Warsh speaks vaguely of “regime change” at the Fed, yet his comment that “inflation is a choice” before the Senate Banking Committee suggests he will not be likely to ease rate policy in the near term with headline inflation rising on still-elevated oil prices. Indeed, the April FOMC post-meeting statement revealed three FOMC members dissented from the vote, preferring to not have an easing bias in the statement, suggesting inflation fears are grabbing more attention among policy makers.  

Meanwhile, the European Central Bank and the Bank of Japan each seem more focused on inflation than growth risks, providing some lift to developed market sovereign bond yields. For the eurozone countries and for many Asian nations, the war has produced higher energy prices and diminished available supply. In the US, oil prices have risen but strong domestic production suggests the fuel will be available, simply at higher prices linked to global markets. Lastly, the US fiscal policy situation remains challenging, with deficit to GDP running above 5% of GDP even while unemployment is low and growth persists.

Buffeted by offsetting forces in each direction, the near-term trajectory for US Treasury yields seems constrained and risk-symmetric. Thus, the Federated Hermes Duration committee has elected to hold at neutral to benchmark duration and to look for tactical trading opportunities should yields approach either end of the recent narrow range.

Read more about our current views and positioning at Fixed Income Perspectives