Update Bonds: Market pressure intensifies

At the same time, volatility in fixed income has picked up, pointing to growing nervousness among investors. Market expectations have shifted quite significantly in recent weeks. Investors now see roughly an 80% probability of another rate hike by year-end from the Federal Reserve, marking a clear move away from earlier expectations of rate cuts. The focus is now on the first Federal Reserve meeting under the new Chair, Kevin Warsh, in mid-June. His key challenge will be to guide policy without adding further stress to an already sensitive bond market. His policy preferences – a lower balance sheet, lower rates, and reduced forward guidance, combined with the view that AI could be disinflationary – may prove difficult to reconcile with current market conditions, particularly given still-elevated inflation.

Inflation remains a concern. It can no longer be explained by energy alone, as underlying components such as services and rents continue to show persistent pressure. In the euro area, inflation climbed back to around 3%, confirming that higher prices are proving stickier than expected. At the same time, the recent decline in core inflation – inflation excluding volatile items such as energy and food – highlights Europe’s higher sensitivity to energy prices. Europe is much more dependent on imported oil than the US.

Yield curve and market positioning
The main driver in bond markets remains the long end of the curve, where rising government debt and ongoing fiscal expansion continue to push yields higher. At the short end, markets are already pricing in a significant number of rate hikes, potentially more than will eventually be delivered by the ECB. However, the situation in Iran still needs to stabilize to avoid second-round inflation effects. Second-round effects occur in response to an initial price spike. A rise in oil prices, for example, could lead to higher wage demands, potentially triggering a wage-price spiral.

What stands out is the disconnect between bond and equity markets. While bond markets remain tense, equity markets are still trading close to their highs.

Portfolio implications
In this environment, we expect markets to take a pause. A period of consolidation or selective risk-off moves appears likely, particularly if pressure on the long end of the curve continues.

We therefore remain cautious and continue to focus on the middle of the yield curve, where valuations look more balanced. Overall, the current divergence between bond markets and risky assets is unlikely to persist. Higher volatility in rates is a reminder that a disciplined and selective approach remains key. Developments around the Strait of Hormuz remain crucial, as they will influence the direction of markets.