US bond markets diverge as Middle East conflict tests Fed outlook

By Gertrude Chavez-Dreyfuss

NEW YORK, April 28 (Reuters) – A Middle East conflict now in its ninth week has splintered the U.S. fixed-income market, with investors in corporate credit behaving as if the Iran war is over while those holding Treasuries remain focused on inflation risks that could limit Federal Reserve easing.

That disconnect underscores the challenge facing the Fed this week. The U.S. central bank’s Federal Open Market Committee is widely expected to keep its benchmark overnight interest rate in the 3.50%-3.75% range at the end of a two-day meeting on Wednesday, as policymakers weigh the possibility that the Iran war will complicate the inflation outlook even as growth risks linger.

For now, market expectations for a rate cut have been pushed out to next year, from prewar forecasts of more than 50 basis points of easing in 2026. Yet in other parts of the bond market, investors are setting aside concerns about the war.   

“From a credit standpoint, spreads are tightening back to low levels,” said Jim Barnes, director of fixed income at Bryn Mawr Trust in Berwyn, Pennsylvania. “Credit investors aren’t risk averse. It’s as if the Middle East conflict is a non-event.”

U.S. high-yield credit spreads have tightened recently and were at 284 basis points over Treasuries late on Monday, ICE BofA U.S. Corporate Index data showed. 

In comparison, high-yield spreads surged to 461 bps in early April last year in the days after “Liberation Day,” when President Donald Trump imposed tariffs on imports from around the world. 

Credit spreads have been wider than 800 bps in various market dislocations in 2013, 2016, 2018 and 2020, according to Ali Hassan, portfolio manager at Thornburg Investment Management, and as wide as 2,000 bps during the global financial crisis of 2008. 

Investment-grade spreads are also near their tightest levels since mid-February, currently at 81 bps, data showed. 

Nathaniel Rosenbaum, head of U.S. high-grade credit strategy at J.P. Morgan, said the tighter spreads stemmed from the notion that “the conflict is grinding to a halt and thus risk markets are letting very strong earnings take center stage.” 

Analysts also say the conflict’s most visible economic effect so far has been energy‑driven inflation, rather than a broad hit to demand or corporate earnings.

While chief executives have warned of rising cost pressures from elevated oil prices, earnings have largely remained resilient, with no sign yet of a widespread downgrade cycle or growing default risk.

DIFFERENT SCENARIO FOR TREASURIES

In the Treasuries market, the mood is a little more cautious, with investors expecting higher inflation down the road with the rise in oil prices. That risk has kept the Fed from cutting interest rates and has even opened the door for wagers that potential rate hikes will be necessary to cool down inflation.

“Energy prices are elevated and while we did get some encouraging CPI (Consumer Price Index) on the core side, it’s clear that the headline drivers on oil prices are not impacting core CPI just yet,” said Noel Dixon, senior macro strategist for State Street in Boston.

Core CPI rose just 0.2% in March and 2.6% year-on-year, data showed, despite a headline inflation number that rose 0.9%, the most in nearly four years.

Dixon believes that the U.S. 10-year yield right now at 4.3% is not fairly valued and has room to rise further due to inflation and higher term premiums — the additional yield investors demand for holding long-term bonds. He thinks that 4.5% is the appropriate level for the benchmark yield right now.

Neutral positioning in the Treasuries market has also increased, according to J.P. Morgan’s Treasury Client Survey as of April 20, highlighting the cautious mindset. For the bank’s active clients, the neutral stance rose by 11 percentage points to 34%, its latest survey showed.

Anders Persson, chief investment officer for global fixed income at Nuveen, noted the 10-year yield has been near its current level for the last few weeks, suggesting investors should take a more neutral stance.

“It’s unclear how this war is going to play out.”

By contrast, some bond investors have positioned long duration relative to their benchmarks, arguing that the market is overstating inflation risks and underestimating the potential drag on economic growth.

Duration, expressed in years to maturity, reflects how sensitive a bond’s price is to changes in interest rates. Extending duration is sometimes viewed as a risk‑seeking move because longer‑maturity debt is more sensitive to shifts in the economic and rate outlook.

In other cases, a long‑duration stance reflects expectations that softer growth or recession risks will ultimately drive yields lower.

Diverging views in the bond market on the balance between inflation and growth underscore the uncertainty surrounding the Iran war’s economic fallout and the Fed’s difficult position, caught between the need to curb inflation and the risk of undermining growth.

“The market is currently overpricing the inflation shock and underpricing the growth element,” said Vishal Khanduja, head of the broad markets fixed income team at Morgan Stanley Investment Management in Boston.

“As the market normalizes, the growth shock will come through, which will bring down real and nominal yields.”

(Reporting by Gertrude Chavez-Dreyfuss, Editing by Colin Barr and Andrea Ricci )