Early on in the Middle East conflict, inflation fears sent bond yields sharply higher as investors worried that central banks would need to raise rates quickly.tadamichi/iStockPhoto / Getty Images
Oil, gold and stocks have gyrated on a daily basis as the prospect for peace in the Middle East rises and falls, but the impact on bond markets has been less obvious.
Nevertheless, experts say the ripples are likely to continue for the foreseeable future.
“We’re seeing a shift where global macro forces, particularly geopolitics and energy, are starting to override domestic fundamentals in driving bond markets,” says Naveed Sunderji, portfolio manager and research analyst at Franklin Templeton Investments in Calgary.
These types of shocks tend to push yields higher in the short term, he says. But over time, higher prices can weigh on demand and growth, which ultimately puts downward pressure on interest rates.
“We also think credit markets haven’t fully adjusted yet – spreads remain relatively tight – but we would expect them to widen as the economic impact becomes clearer,” he says.
A key question is whether the impacts of the conflict in the Middle East are temporary or more long-lasting.
“There will be some immediate, short-term effects as supply shocks push up the prices of key inputs and feed into broader inflation,” Mr. Sunderji says. “While some of that may fade, the overall impact could be more persistent than markets are currently pricing in.”
He notes that disruptions to infrastructure and supply chains can take time to resolve, and he expects to see more structural shifts emerge, such as companies holding higher inventories to protect against future shocks.
Mr. Sunderji notes that Canada entered this period with a relatively soft backdrop, including weaker growth, lower inflation and a lower policy interest rate than the U.S.
The Middle East conflict introduces new inflation risks tied to commodity prices, he says. While Canada is an energy exporter, it’s also more sensitive to higher interest rates because of the housing market’s importance to the economy.
“While higher energy prices can provide some support, the benefit is likely more muted than in past cycles,” Mr. Sunderji says. “As a result, Canada has less capacity to absorb higher interest rates, which should limit how much yields rise relative to other developed markets.”
He believes investors should stay shorter in duration and focus on higher-quality issuers.
“We’re still in the early stages of this shock and there is potential for further volatility in interest rates and credit,” he says. “Importantly, corporate spreads, particularly at the longer end, remain tight by historical standards. In our view, investors are not being compensated adequately to move down the credit spectrum right now, so maintaining a higher-quality bias makes sense.”
Some investors worry about the risk of a 2022 scenario, when stocks and bonds both had a terrible year, but Mr. Sunderji says there are important differences.
“Demand is weaker today, which should help limit inflationary pressure relative to what we saw coming out of the pandemic,” he says.
“At the same time, the current supply shock could be larger in scale, which increases inflationary pressure while also creating downside risks for growth.”
In such an uncertain environment, he advocates greater caution when adding risk to portfolios.
Taylor Schleich, director of economics and strategy at National Bank Financial Inc. in Toronto, says that early on in the Middle East conflict, inflation fears sent bond yields sharply higher as investors worried that central banks would need to raise interest rates quickly, regardless of the underlying economy.
“These fears have moderated somewhat as central banks have calmed investors and some de-escalation in the conflict has helped, too,” he says.
“But you can see that on days when tensions rise, yields do, too. Clearly, inflation is in the driver’s seat right now. Other macroeconomic data still have sway, but relatively less so, as geopolitical developments can dwarf these impacts.”
Mr. Schleich says the impact of the war in the Middle East is largely a temporary phenomenon, but more clarity will be needed before investors can go back to trading on overall macro fundamentals.
He adds that this is “clearly an era of heightened geopolitical volatility” that will continue even after this war ends, which will mean more volatility in bond markets.
Mr. Schleich says many initially assumed that Canada’s role as a net energy exporter would mean its economy would benefit from higher oil prices and Government of Canada bond yields rose more than those of some other countries.
“However, with underlying economic data remaining weak, we’re now starting to see expectations for [Bank of Canada interest] rate hikes fading,” he says. “Notably, these BoC hike expectations have faded more than expectations for other central banks.”
With term premiums and inflation risks rising, there’s less safety hiding in bonds, he says, especially longer-duration debt.
“With a shock like this that’s all about inflation, it’s not hard to envision a scenario where bonds have a bad year,” he says. “Hiding out at the front end of the [yield] curve may be the safest move for many in 2026.”