The state of play in fixed income as Iran tensions reignite

With tensions in the Strait of Hormuz increasing over the weekend and markets getting used to oil prices well in excess of $100 per barrel, this seems an opportune moment to zoom out and look at the state of play in fixed income markets, considering the unsettling reality of a longer-than-expected conflict in the Middle East.

Starting with credit, spreads have been remarkably well behaved since the war began at the end of February. Primary markets were a bit quieter for a couple of weeks in March, but were never really closed. Primary volumes recovered swiftly as soon as there was a hint of negotiations, and they have remained buoyant ever since. Financials, high yield, investment grade and ABS syndicate desks have been busier over the last few weeks and have been met with healthy demand as investors have been happy to put cash to work, even if new issue premiums have been uninspiring. There are a few reasons for this resilience.

First, corporate fundamentals are still strong as evidenced in the Q1 earnings season. Though one could argue that these numbers are backward-looking and do not fairly represent the new reality of higher oil prices, it is also true that the starting point does matter. When an external shock comes at a time of weaker fundamentals, the consequences are more severe than otherwise. Second, anecdotal evidence suggests positioning in risk assets was relatively light coming into the conflict. It is a brave thing to do to recommend going all-in on risk when spreads are near all-time lows, and therefore it seems to us that both sell side strategists and buy side fund managers have ample room to add risk if spreads widen or primary issuance looks attractive. Fund flows have also held up reasonably well. Altogether, we have not seen a single day of panic selling that would suggest forced liquidation of positions to raise cash. The other side of this resilience coin is that, even if we advocate holding more credit than government bonds, we are not overly tempted to increase exposure to spread products at this juncture, though as active managers, we always tend to find a few bonds here and there that look worth rotating into.

Looking next at rates, government bonds have experienced a larger move than credit spreads. The ghosts of 2022’s energy crisis and central bankers’ overuse of the word “transitory” have certainly lowered their tolerance for inflation increasing rapidly, whatever the cause. In the current situation, we are dealing with a large supply shock impacting chiefly oil prices but also that of other commodities. Tightening monetary policy does not solve supply side shocks, but acts on inflation by dampening demand, which is not a great outcome if the economy is already suffering because of higher oil prices. A supply shock can be overlooked by central banks, but they need to be convinced that the shock is temporary and that there is limited pass-through into inflation expectations. Given the uncertainty as to when this shock will end, central bankers remain on the fence and stand ready to act if the conflict does not sort itself out.

Europe, as an energy importer, is more vulnerable to energy shocks. This is not to say that inflation will necessarily be higher. In fact, inflation in the Eurozone is at 2.6% while in the US it jumped to 3.3% in the last reading. The larger impact, in theory, is via growth, as reduced private consumption due to higher prices is not offset by additional investment or production from energy companies when you are an energy importer. Despite this, 2026 growth projections have been revised down equally (by 0.3%) in the Eurozone, the UK and the US, according to the Bloomberg consensus.

Given the larger moves in government bond yields, curves are anticipating the European Central Bank (ECB) will take monetary policy rates from 2% to 2.85% in 12 months’ time. Uncertainty is, of course, running high at this stage, but we struggle to see a scenario where the ECB takes rates higher than what is currently priced in. The higher oil prices go, the higher the short-term inflationary impact will be, but also the larger the demand destruction. We think it would  be a mistake to extrapolate that higher oil prices translate into higher monetary rates in a linear fashion. The Bank of England (BoE) is anticipated to have raised rates to 4.5% in a year’s time, three hikes from current levels. Again, while this is scenario isn’t completely out of the question, it is difficult to imagine the BoE will hike rates by more than this in response to the oil shock. In the US, rate cuts have been priced out and a mild increase in rates priced in. While volatility will continue, we take comfort in the fact that the moves in rates have been large, and further upwards moves are harder to envisage as much is already priced in. We do note though that longer maturities are less affected than shorter maturities by shifts in monetary policy expectations. In other words, the fact that there is arguably a lot priced in at the short end does not mean the long end cannot sell off further, steepening the curve.

Finally, it is worth saying a few words about how bad the inflationary shock is actually looking in Europe. For obvious reasons, some market commentators were quick to doom Europe to a similar outcome to that of 2022. As Exhibit 1 shows, natural gas prices have moved significantly in the last couple of months, but the moves are smaller than those in 2022 by orders of magnitude. Electricity prices show a similar picture, though it does vary depending on which country we are looking at. This is important, as the impact on growth, inflation and inflation expectations may be more limited than some might think. The ECB is keeping its options open, but there is a realistic scenario in which it only hikes once as a precautionary measure, and that is it.

Given the combination of high yields and solid fundamentals, we think fixed income markets can deliver healthy returns for those who remain invested. Default rate projections have not really moved, and with yields several basis points higher than at the beginning of the year, we think a portfolio biased towards higher quality credit and neutral duration is a solid proposition. Maintaining high liquidity will be particularly important, offering opportunities to investors during periods of volatility. While we cannot rule out additional sell-offs in the asset class, we stand ready to make changes and potentially add risk if markets do sell off.