THE ECONOMIST: Inflation or recession? The tug of war in bond markets

The yield on ten-year American Treasury bonds is perhaps the world’s most important number, and for weeks it has been all over the place. Hundredths of a percentage point (basis points, in finance speak) matter in this market, because the Treasury’s borrowing costs underpin those for everything from mortgages to corporate bonds. It stood below 4 per cent on February 27, the eve of the American-Israeli war on Iran, jumped above 4.4 per cent by March 27 and has since dropped back down.

For many Americans, the difference between 4 per cent and 4.4 per cent is that between being able to afford a new house and not.

It is not just America: governments’ borrowing costs are in flux almost everywhere. At one point on March 23 Britain’s ten-year yield topped 5.1 per cent, its highest since 2008. Germany’s has hit 3.1 per cent, higher than at any point since the euro zone’s sovereign-debt crisis.

Japan’s has reached 2.4 per cent for the first time since 1997. All saw bond yields soar in the wake of the Iran war, then fall back over the past few days.

What is going on? Hopeful observers might conclude that borrowing costs have dropped recently because hostilities in the Middle East will soon be over, allowing oil to flow freely through the Strait of Hormuz. After all, the fall in yields has come as Donald Trump, America’s president, has seemed increasingly desperate to end the war, alternately threatening to “obliterate” Iranian infrastructure and touting success in peace talks.

With Mr Trump searching for an off-ramp, the odds of lower energy costs and less strain on government budgets — both of which should pull bond yields down — might be improving.

Life’s optimists, however, generally do not pursue careers in bond investing. The whole job involves considering just how gloomy things might get. In the case of the Iran war, this means fretting about the twin-headed monster of stagflation: economic stagnation combined with high inflation. Borrowing costs are whipsawing because these two dangers tug them in opposite directions.

When bondholders think inflation will flare, they demand higher yields both as compensation for the erosion of their principal’s purchasing power, and because they expect central bankers to raise rates to cool prices. When they think growth is stalling, they accept lower yields because a more sluggish economy reduces demand for their capital, and because monetary policy is likely to be loosened to help reheat the economy.

Broadly, the governments whose borrowing costs have jumped highest are those most exposed to inflationary pressure from the closure of Hormuz. The OECD produces regular forecasts of growth and inflation for its members, most of which are well-heeled countries. Comparing the last two sets, published in December and March, gives a picture of how their prospects have been changed by the Iran war.

The OECD raised Britain’s inflation forecast by the most, pencilling in a cumulative change of two percentage points over 2026 and 2027.

The yield on ten-year gilts has, accordingly, risen by over 0.4 percentage points since the start of the year — more than any other large, rich democracy in the G7. (India, not yet in that select club but also an energy importer, has seen similar jumps in both its inflation forecasts and borrowing costs.) In Canada, for which the OECD has raised its inflation projection by only 0.3 percentage points, ten-year yields have barely budged.

By comparison, the changes to the OECD’s growth forecasts have been mild. But they were published on March 26th, and since then bondholders’ natural pessimism has set in. Early in the war traders bet that the Federal Reserve would stop cutting rates and might even raise them, to contain the inflationary effects of the energy shock. Now they are pricing in an increasing probability of cuts once again.

To be fair, theory suggests that central bankers should “look through” price rises caused by supply-side shocks such as the current energy crisis. After all, tightening monetary policy does nothing to fix supply shortages. Slashing rates during even a brief inflationary surge, however, might exacerbate it — a risk worth taking only if the economy urgently needs support.

The longer the Strait of Hormuz stays shut, the worse such worries will get. The OECD’s projections were based on the assumption that energy shortages will begin easing within weeks, and that disruption in 2027 will be “limited”. It reckons a longer closure could subtract 0.5 per cent from global GDP next year, while adding 0.9 percentage points to inflation. If that comes to pass, bond traders will be in two minds for a while yet.