Inflation "reignites"! The breakdown of US-Iran negotiations shatters expectations of a rate cut, prompting bond traders to urgently delay expectations of a rate cut until 2027.

The failed peace talks between the United States and Iran have further shifted the focus of the bond market towards inflation and strengthened expectations that interest rates will remain high for a longer period of time. Rising energy costs may worsen already high price pressures and delay the Federal Reserve's interest rate cuts, which is the core concern for investors in the $31 trillion US government bond market. Traders and strategists from Pacific Investment Management Co (PIMCO), Brandywine Global Investment Management, and Natixis North America are on high alert, expecting yields to remain high until the inflation outlook becomes clearer. Most institutions are hesitant to make large adjustments to asset allocation until then. Data released on Friday showed that the March inflation rate reached a new high since 2022, driving the yield on the 10-year US Treasury bond above 4.3% and prompting traders to lower their expectations of rate cuts for the year. On Monday, after the US-Iran weekend negotiations broke down, President Trump ordered the blockade of the Strait of Hormuz, further pushing the yield up by 3 basis points to 4.35%. John Briggs, Head of US Rate Strategy at Natixis North America, noted, "The tide has indeed turned towards inflation. While the job market remains stable, the lack of structural vitality is evident, making inflation the core issue at the moment." This shift highlights a rapid turnaround in market narratives: oil prices are now much higher than before the conflict, making inflation concerns harder to ignore. For many investors, they must also deal with the risk that the prolonged conflict may eventually drag down economic growth, making it more urgent to consider how long the high energy costs will last and eventually transmit to consumer prices. The yield on Japan's 10-year government bonds has reached its highest level since 1997, while Australia and New Zealand have seen at least a 6 basis point increase in their equivalent term government bond yields. Meanwhile, the US labor market remains strong. The increase in non-farm employment in March was the highest since late 2024, with the unemployment rate dropping to 4.3%, making the case for an interest rate cut more complex. Kevin Flanagan, Head of Investment Strategy at WisdomTree, stated that it will take at least three months to obtain clear inflation data. He also added that with the inflation rate still about one percentage point above the Fed's target and the unemployment rate hovering around 4.5%, "the urgency for rate cuts has decreased from this point." Traders have adjusted their expectations, pushing back the timing of the Fed's next rate cut by 25 basis points to mid-2027. Pre-conflict market expectations had anticipated two rate cuts this year, but the Fed has remained steady since lowering the policy range to 3.5%-3.75% in December last year. Uncertainties regarding the temporary ceasefire, the situation in the Strait of Hormuz, and oil price trends continue to pressure the front-end of the US bond yield curve, keeping market expectations for monetary policy unstable. Andrew Jackson, Chief Investment Officer at Vontobel, said, "To some extent, the Fed's job has become a bit easier because they can cite uncertainty in medium-term inflation trends." He pointed out that the Fed is "more likely to pause rate hikes for a longer period than previously expected," making the yield curve from three to five years more attractive. Others are content to sit on the sidelines for now. Jack McIntyre, Portfolio Manager at Brandywine Global Investment Management, said he is currently underweight in US bonds. He stated, "If the ceasefire holds and oil prices continue to underperform, the market will refocus on the labor market. If circumstances change, we will adjust our views quickly." The inflation report for March showed a 0.9% increase in prices, driven mainly by a surge in gasoline prices, while core prices excluding food and energy were slightly lower than expected. This increase is in line with expectations, with several companies including Delta Air Lines and the US Postal Service signaling price hikes. Molly Brooks, US Rate Strategist at TD Securities, said, "Without a deterioration in economic growth, the Fed needs to see inflation surging downward and reports showing easing before they will feel comfortable continuing rate cuts. Despite recent resilience in the labor market data, the Fed's dual mandate is becoming increasingly crucial." Minutes from the Fed's meeting on March 17-18 indicated that officials saw risks on both sides before the conflict, with "the vast majority" mentioning upside risks to inflation and downside risks to employment. Daniel Ivascyn, Chief Investment Officer at PIMCO, said the surge in energy prices has intensified this tense situation, creating a "supply-side inflation shock." He said, "With inflation remaining high and financial assets generally under pressure, this is indeed a reasonable market risk." The company prefers high-quality bonds and seeks to profit from any market dislocations. Against the backdrop of changing prospects for Fed policy, there is still an anchor point: the yield on the 10-year US government bonds has mainly fluctuated between 4% and 4.5% since mid-2023, averaging around 4.25%. Flanagan said, "There are still many uncertainties, and the yield on the 10-year bond has returned to the middle of its long-term range." Overall, the market remains unstable in its expectations of monetary policy amidst uncertainties surrounding the ceasefire, the situation in the Strait of Hormuz, and oil price trends.