Fixed income scenarios for the current market environment
Global fixed income strategy note: geopolitical risk, inflation uncertainty, and the evolving central‑bank policy outlook
The bond market backdrop is influenced by escalating geopolitical risk centred on Iran, and renewed energy-driven inflation uncertainty. In this note we detail the immediate impact on fixed income assets—and scope out the likely impact of different military outcomes on bond markets.
Government bonds have historically been safe havens, but many have posted negative returns since the conflict began. Rising oil prices have fuelled expectations of rising inflation, constraining central banks and delaying the transition toward easier monetary policy. Credit spreads have widened from historically tight levels, as growth concerns intensify.
Fixed income market impact
The US Treasury curve has undergone a notable shift. February’s yield decline has already been more than reversed this month, with yields moving higher across the curve. The front end has reacted to the repricing of central bank policy trajectory. The longer end has been undermined by inflation and borrowing concerns.
This move has been in parallel with a modest bias towards bear flattening, as policy expectations have been reset. Shorter-duration strategies have proved more defensive due to their lower price sensitivity to yield moves, although performance has turned negative for even the most short-dated government bond exposures.
Yields further along the curve have been driven by higher inflation expectations, with 10-year breakevens around 10 basis points (bps) wider from their end of February levels.1 At the same time, growing fiscal concerns—reflecting fears of higher military spending and energy-hampered slower growth —have increased longer-maturity term premia.
Investment grade spreads were already on a widening trend in February, after reaching historically tight levels in January. February’s move reflected growth concerns and cascading impacts over AI hitting software-related spreads. Higher energy prices and a more restrictive central bank outlook, reinforced concerns over growth, and deterioration in balance-sheet quality.
High yield spreads have moved in the same direction also pressured by concerns over private credit. Performance has been more resilient than investment grade, supported by their higher coupons and shorter durations.
The stronger USD and fading risk appetite has reversed a positive start to the year for Emerging Market local currency debt.
A Ukraine framework?
The fixed income response to the 2022 invasion of Ukraine provides a useful framework for interpreting current market dynamics. The initial phase was a flight to safety. Government bonds rallied sharply. However, as the energy shock filtered through to inflation data, central banks were forced into a more aggressive tightening cycle. Credit spreads widened, emerging market (EM) assets experienced heightened volatility, and duration ceased to offer reliable protection.
The very brief period of bond market support so far this year suggests that investors have internalised the lesson that modern geopolitical shocks tend to transmit primarily through energy and inflation channels, rather than through a simple deterioration in risk sentiment. There are important differences. This time energy prices have risen but remain relatively contained compared with 2022. The US economy is also in a late stage of the cycle, leaving it more vulnerable to slowdown—potentially limiting inflation pass-through.
Gulf scenarios
To frame portfolio considerations, we have outlined three plausible macro scenarios over the next twelve months.
Scenario 1—Rapid de‑escalation
Diplomacy contains the conflict. WTI oil prices retreat into a $70–80 USD range, limiting inflation pass-through. Central banks, confident that inflation is not going to remain elevated, resume rate cut cycles later in the year.
This broadly aligns with market expectations, given the stated aim at the start of the conflict was for a short campaign.
- Rates: Government yields retreat towards the middle of their recent range,with a flattening bias towards the 10-year part of the curve as inflation concerns subside.
- Credit: Shipping takes a while to normalise but falling oil prices support growth expectations, allowing credit spreads to compress.
- Other assets: Emerging‑market assets—particularly local‑currency exposures—benefit from improved risk sentiment and the likelihood that the US dollar resumes its depreciating trend.
Key exposures: portfolios focus on the belly of the curve, with exposure to investment grade credit benefitting from falling yields and spread compression. Risk assets that were performing before the conflict commenced, such as emerging-market local-currency debt, and convertible bonds, could broadly rebound.
Scenario 2—Prolonged conflict
A continuation of the current conflict without a decisive escalation or resolution. Oil prices remain elevated in a $90–110 USD range. Inflation proves sticky and growth is challenged, creating sizeable constraints to central banks. Equities come under increased pressure.
- Rates: would initially remain rangebound, with yields vulnerable to moving higher on inflation pressures. As it becomes clear that a cessation of hostilities is unlikely, short-dated yields have a bias to drift lower if weaker growth comes to dominate central bank thinking. This would result in a steeper yield curve, as longer dated breakevens catch-up with the widening seen at the front end of the curve.
- Credit: Spreads, particularly in high yield, widen as the market factors in a tougher economic backdrop—and the resultant impact on corporate balance sheets. Spreads have widened but they remain tight to their five and 10-year average and tighter than the wides seen at ‘Liberation Day,’ leaving further scope for widening.
- Other assets: Floating‑rate assets provide protection against delayed rate cuts, while shorter duration helps mitigate inflation risk in the early phase of the scenario. As growth momentum weakens taking on more duration could be attractive.
Key exposures: In this environment, portfolios may prioritise resilience over outright return potential. Short-duration strategies—such IG securitised credit—may be preferred initially, with scope to add duration as growth momentum fades. Given the changing backdrop, active management of portfolios may offer advantages. Where interest rate risk is taken, the focus should be on real rates. Treasury Inflation-Protected Securities (TIPS) provide inflation protection.
Scenario 3—Escalation
A more severe outcome would involve further disruption to the Strait of Hormuz and a broadening of the conflict, triggering a sharp rise in oil prices above $130 USD per barrel. This would represent a significant headwind to growth, conceivably pushing parts of Europe into recession. Such a global shock would hamper risk-asset performance, pushing investors towards safe-haven assets.
- Rates: A pronounced slowdown in growth would ultimately pull long‑term yields lower as demand destruction outweighed the initial wave of cost-push inflation. The yield curve would likely steepen but extending duration could benefit from greater upward price momentum from the shift to lower yields.
- Credit: Spreads would widen sharply across both investment grade and high yield, as markets turn risk averse. Concerns over the resilience of corporate balance sheets would intensify in a late-cycle economy.
- Other assets: All risk assets could come under pressure. Emerging-market debt spreads would widen. Slower global growth would mean caution over EM local currency exposures.
Key exposures: Capital preservation becomes paramount. High‑quality government bonds could regain their defensive role, while inflation-linked securities may provide protection against the initial price-rise impulse. Exposure to riskier credit and emerging markets would need to be more carefully monitored. Where credit exposure is sought, investors could focus on US investment grade, given the more resilient nature of the US economy.
Conclusions
The market is pricing a brief conflict but risks of a prolonged dispute remain. Higher energy prices raise inflation risks. Recent rhetoric suggests central banks are unlikely to repeat the 2022 mistake of assuming transitory price shocks.
Markets have re-priced accordingly, pushing bond yields higher. If peace is arrived at soon, and normal shipping and oil production resume, a partial reversal of this move is likely. A more protracted war—and an increase in inflation—would be damaging for fixed income. Short duration and inflation-protected strategies can help improve portfolio resilience, although there is likely to be a tipping point where persistently higher energy prices lead to demand destruction. Once clear evidence of slowing growth emerges, high-quality government bonds would be expected to regain their defensive role.