Staying nimble as rates market uncertainty endures

Key points

• Carry-driven markets have given way to volatility and inflation risk, with rates more significantly impacted than credit.

• Markets are pricing inflation risk rather than an imminent growth downturn, with returns supported by a meaningful “yield cushion”.

• Energy constraints are pushing inflation risks structurally higher, complicating central bank decisions.

Before the outbreak of conflict in the Middle East at the beginning of March, moves in both rates and credit markets had been relatively subdued. Volatility was limited, spread movements were contained and fixed income strategies could largely rely on carry and selective participation in new issuance to generate returns.

That environment has now shifted decisively. What markets are experiencing today is not simply higher volatility, but a fundamental change in where risks are being priced. For active managers, this is where flexibility in portfolio construction can really add value.

Rates absorb the shock, credit remains resilient

Since the onset of the conflict, the dominant adjustment has occurred in rates rather than credit. Bond yields moved sharply higher, driven by heightened inflation expectations and the response from central banks. By contrast, credit spreads have remained remarkably well behaved.

This divergence is telling. Markets are clearly focused on inflation risk rather than an imminent growth shock. This assessment aligns with incoming macroeconomic data and has underpinned the resilience of credit spreads, despite the scale of movement in government bond markets.

For fixed income investors, this environment highlights the importance of what is often referred to as the “yield cushion”:

• Higher starting yields and steady carry have helped buffer portfolio returns, even as rates markets have been more volatile.

• While challenging, such periods can ultimately prove valuable, particularly for investors assessing how flexible a given active manager really is when market conditions change.

Oil, inflation and the limits of “paper” prices

Much of the current inflation debate centres on energy - and in particular, oil. But the most important signal is not always found in the most widely used oil benchmarks such as WTI¹ or Brent Crude. What matters more for inflation and economic activity is the availability of physical oil.

Measures such as “dated Brent” — which require actual physical delivery — point to a meaningful shortage, one that exceeds even the stresses seen during the start of the Russia–Ukraine conflict in 2022. Since hostilities intensified with Iran, traffic through the Strait of Hormuz has collapsed, underscoring the disruption to global energy supply chains.

The economic implications are potentially serious. Even if geopolitical tensions are resolved quickly, the damage to production capacity and logistics suggests physical oil shortages may persist. This supports the case for structurally higher inflation outcomes than markets had previously priced.

Oil also matters far beyond fuel costs. It underpins fertilisers, clothing production, industrial metals processing and large parts of global manufacturing. Prolonged constraints risk feeding through to supply chains, affecting food prices and industrial output.

Reframing inflation risk - and central bank choices

Against this backdrop, inflation expectations need to be reassessed. Even with some resolution to geopolitical tensions, oil prices are expected to remain elevated and are likely to stay above levels consistent with pre-conflict inflation forecasts.

That creates some difficult trade-offs for central banks. In the UK and euro area, inflation expectations have been revised higher - even as growth (in the euro area at least) remains relatively resilient. In the US, strong employment data complicates the path forward, forcing policymakers to balance inflation risks against still-solid economic momentum.

Japan has been much more impacted by the closure of the Strait of Hormuz than these other developed markets. Before the conflict, more than three quarters of Japan’s energy supplies passed through the Strait. We continue to see April as the right moment for the Bank of Japan to hike rates, especially in light of ongoing currency weakness, and our positioning reflects this view. 

Even if policymakers opt to delay, that decision is likely to weigh on the yen, which would continue to weaken until their commitment to currency support is ultimately expressed through higher rates in subsequent meetings.

There are clear thresholds that matter. Moderately elevated oil prices may lift inflation without derailing growth. However, if prices remained significantly higher, this could trigger a more disruptive inflation regime, eventually tipping economies into recession and forcing a sharp repricing across risk assets, including credit.

Portfolio implications: Caution, liquidity and selectivity

In such a fluid environment, the key risk is being positioned too heavily around one outcome. Some investors have maintained persistent short credit risk positions, only to see spreads remain tight for longer than expected. Others, running elevated risk, have been caught out by relatively small spread moves that translated into outsized performance losses.

Volatility magnifies mistakes. It also shortens reaction times.

• When volatility is up, maintaining sufficient liquidity and staying closer to benchmark risk profiles can be an advantage, particularly when true dislocations have yet to emerge.

• These are often the conditions that allow active bond managers to preserve capital first, while retaining the flexibility to deploy risk when opportunities become more compelling.

Staying nimble as uncertainty endures

The broader message for fixed income investors is clear: many of the forces shaping markets are only starting to be reflected in prices. Volatility is likely to remain elevated, headlines will continue to drive sharp moves and conviction trades will carry greater risk.

In this environment, flexibility, liquidity and disciplined risk management matter more than ever. The goal is not to predict every outcome, but to remain nimble enough to respond as the facts evolve, preserving capital while positioning portfolios to capture opportunities when real dislocations finally emerge.

¹ West Texas Intermediate.