Conflict in the Middle East has inflicted a severe blow to global bond markets. Driven by surging oil prices that have heightened inflation expectations, the global bond market lost over $2.5 trillion in value during March, setting a course for its largest monthly decline since September 2022, with the specter of stagflation looming over markets.
As of March 23, aggregate indices compiled by Bloomberg show the total market value of global government bonds, corporate debt, and securitized debt has fallen to $74.4 trillion from nearly $77 trillion at the end of February, marking a monthly decline of 3.1%. This bond market downturn is particularly noteworthy, as geopolitical turmoil typically prompts capital inflows into bonds for safety, making this trend a clear departure from the norm.
Tensions in the Middle East continued to escalate. The Iranian armed forces issued a statement indicating that if the U.S. President's threat to attack Iranian power plants is acted upon, Iran will immediately implement four "punitive" measures, including a comprehensive closure of the Strait of Hormuz until the damaged power facilities are rebuilt. The bond sell-off accelerated in response, as markets rapidly priced in stagflation expectations, placing pressure on several central banks to potentially raise interest rates even amid an economic downturn.
The bond market decline, hitting a three-year high, was led by sovereign debt. Data shows the global sovereign bond index fell 3.3% in March, while corporate bonds declined 3.1%. Although the scale of the bond market contraction is smaller than the approximately $11.5 trillion loss in global equities, the movement is abnormal for fixed-income assets, which usually act as a safe haven during turbulent times.
Rising oil prices directly erode the real yield value of fixed-rate bonds, pushing interest rates higher across various maturities. U.S. Treasury yields have climbed to multi-month highs, recording losses for a third consecutive week. The Asia-Pacific region was not spared: government bond yields in India, Japan, and South Korea all moved higher; Australia's 10-year bond yield rose on Monday to its highest level since 2011; New Zealand's equivalent yield also reached a new high for 2024.
With stagflation expectations intensifying, central banks are facing a dilemma. Persistently high oil prices are forcing major central banks to reassess their monetary policy paths. An interest rate strategy team at BNP Paribas noted in a client report last week that if energy prices remain elevated and the job market stays stable, the Federal Reserve might signal a potential rate hike at its April policy meeting.
A member of the European Central Bank's Governing Council stated last week that if the conflict with Iran further increases price pressures, the ECB could consider raising rates as early as next month. A senior economist at a Hong Kong-based bank pointed out, "Higher inflation pressures are constraining the maneuvering room for central banks. Some will be forced to hike rates during an economic downturn to curb inflation and prevent currency depreciation."
The chief market strategist at StoneX Group commented in an interview, "The market is starting to price in what I believe is an impending stagflation shock, and the longer this conflict lasts, the higher oil prices could go."
Whether the current bond market decline will persist depends heavily on the trajectory of the conflict and the actual disruption to oil supplies. The combination of narrowing policy options for central banks, rising geopolitical risk premiums, and deteriorating growth prospects is making the environment increasingly challenging for fixed-income investors.
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