Those concerns were joined, if not overtaken, by war. Prior to the announced ceasefire, most market reactions were in the predictable directions: stocks down, government yields and the dollar up, spreads wider, and oil (Brent c.+80%) and European gas (c.70%) showing the biggest moves.
Given the war’s unpredictability of the conflict to date and the potential fragility of the April 7 ceasefire, our economists developed two scenarios aptly labelled the “adverse” and the “less adverse”. In either case, when compared to pre-war conditions, fundamentals are all worse, with elevated uncertainty, higher inflation and bigger deficits to fund fiscal stimulus and defence spending.
At the end of 2025, growth continued and inflation remained above target. Accordingly, our “central bank clock” showed central banks moving from rate cuts towards the hiking side of the cycle.
Since then, the conflict’s upward push on inflation has accelerated the cycle, generally pulling the timetable for central bank rate hikes forward. In particular, central banks with single mandates (i.e., solely inflation targeting), like the European Central Bank, are now likely to hike this year. With its dual mandate of maximum employment and 2% inflation, the US Federal Reserve is conspicuously at the dovish end of the spectrum.
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Although the worsening inflation outlook is clear, the Fed is expected to refrain from hikes given the downside risks to growth. Net-net, the markets have moved from pricing in rate cuts to anticipating an unchanged Fed funds rate over the coming quarters.
Uncertainty aside, on balance, markets’ pricing of monetary policy rates relative to our forecasts appears to be a bit on the hawkish side. Central bankers’ zeal to reduce inflation to target may be dampened by downside growth concerns stemming from the war.
While the world’s higher inflation trajectory is a bond market negative, investors appear confident that central banks will succeed in containing inflation. This is evident in the market’s inflation swap pricing as well as the increasingly range-bound movement in long-term rates since the end of 2022. This supports the view that interest rates may be near longer-term equilibrium levels that may not only account for the level of growth and inflation, but also include a premium for the governments’ high deficits and heavy issuance.
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To some extent, our concerns regarding spread products have materialised. At the tight end of historical ranges, spreads were vulnerable to a shock, like the outbreak of war in the Middle East. Furthermore, the extant pre-war risks stemming from AI and private credit not only remain, but may even be aggravated by the conflict.
Overall, however, we expect credit concerns to remain isolated. As discussed in our economic outlook, the world’s economies and credit fundamentals over the last few post-Covid years have weathered a number of shocks — the 2022 increase in interest rates, Russia/Ukraine conflict, collapse of Silicon Valley Bank and US tariffs. This leads us to expect an overall modest negative impact, resulting in a non-recessionary “U” shaped-effect on growth.
In any event, we see credit fundamentals as remaining fairly stable, suggesting that on the far side of the current fog, credit will outperform via carry as well as through opportunities to add value through sector and issue selection.
In the weeks ahead, investors may be further unsettled by the course of events and the potential for a credit downcycle. As a result, over the near term, caution is warranted as volatility across markets may continue.
The anxiety of the first quarter pushed government rates higher and credit spreads wider — a combination that has boosted all-in yields on broad market indices and a range of fixed income products. That is the silver lining: with yields back to the highest levels since those prior to the financial crisis, the slow-go bull market — where respectable yields eventually translate into solid returns over the long term — looks set to continue.
After all, over the long term, yield is, more or less, destiny.
Robert Tipp is chief investment strategist and head of global bonds at PGIM
