The risk of bias
Bond yields moved mostly sideways this week, after jumping higher last Friday following the May US employment report. That report led markets to expect a full rate hike from the Federal Reserve by the end of this year, quite a contrast against the 2.5 cuts that had been expected as recently as February.
The Fed may prefer to keep an easing bias, especially with Kevin Warsh taking over as the Chair. But high energy prices and inflation, a solid labour market and decent economic growth could force the Fed to hike or at least to remain on hold. The press conference following Warsh’s first policymaker’s meeting as the Chair is next week and certainly something for investors to pay attention to.
On Thursday, the European Central Bank (ECB) hiked rates by 25 basis points, which was no surprise and had been fully reflected in market pricing for several weeks. The press conference following the decision confirmed a hawkish bias. The ECB seems keen to avoid falling behind the curve with rate hikes, as happened to developed-market central banks following the pandemic.
Credit markets remain resilient, seemingly not bothered by the Strait of Hormuz remaining effectively closed and the ceasefire between the US, Israel and Iran coming under further pressure. Credit markets appear biased that a deal will be reached that reopens the Strait of Hormuz in time, before a physical lack of oil (rather than just higher prices) causes problems to the real economy. We see that as complacent and think that the risk to spreads is increasing. Not only because US President Donald Trump appears ready to return to more frequent bombing of Iran, but also because time is running out to reopen the Strait of Hormuz before shortfalls occur.
Similarly, we see a risk in the biases at the Fed and ECB that could lead to policy mistakes. The US economy is not dependent on Middle East oil and continues to be robust, while the build out of artificial intelligence has already added to inflation. The European economy, on the other hand, being an energy importer, looks much more vulnerable. If the Strait of Hormuz remains closed, then rate hikes may well be needed to avoid inflation from broadening in the US. In Europe, the more likely risk is a recession, which rate hikes would only exacerbate.