Update Bonds: Different market perspectives
In the first month of the Iran war, risk-free government bonds and risky assets moved in tandem, in the opposite direction of oil prices. Interest rates are still moving in lockstep with oil prices, pushing them lower this week as hopes for a reopening of the Strait of Hormuz rose again.
More recently, however, risky assets have become less sensitive to oil price changes and increasingly respond to a surprisingly resilient global economy. In bond markets, risk free rates and risk premia even started to move in opposite directions during May. (Risk-free rates are the yield to maturity on investments considered to carry no risk, such as high-quality government bonds. Risk premia refer to the additional yield investors demand as compensation for investing in assets that are perceived as riskier.)
Investors seem to expect the Iran war to have more impact on inflation and less on economic growth, in line with the message of recent economic data. This explains the difference between the behaviour of interest rates and risky assets. Bond and equity investors may share the same geopolitical view, but still look at their specific markets from different perspectives. For risk-free government bonds, inflation and central bank policy are by far the most important factors. Economic growth considerations are the more dominant perspective for riskier assets.
The global economy has been remarkably flexible and resilient in coping with energy market disruptions so far. As the Hormuz closure continues, however, we are moving closer to potential tipping points caused by physical energy shortages. When stockpiles run (too) low, steep price rises are probably needed to reduce demand enough to balance the significantly lower supply.
Especially Europe looks vulnerable to energy disruptions and both consumers and companies are aware, as reflected in falling confidence indicators. Meanwhile, the European Central Bank is highly focussed on inflation, while the US central bank (Fed) is under political pressure to place emphasis on unemployment. For now, however, the new Fed chair Kevin Warsh is more likely to work on the way the Fed communicates. He might reshape common means of Fed communication, such as press conferences and forward guidance, before trying to convince the Fed policy committee to deliver the rate cuts that President Trump still expects from him.
Next week will provide investors with a lot of new data on the US labour market and company confidence surveys from ISM and S&P. However, investors should not (yet) forget about more negative scenarios as long as the strait of Hormuz remains closed. That said, the scale of the inflation shock will probably be much smaller than we saw in 2022-2023.