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(Bloomberg) — Bonds are reasserting themselves as a hedge against risk as investors worried about growing tensions in the Middle East shift their focus from inflation to slowing growth, said Citadel Securities.
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“There are signs we are approaching a shift,” Nohshad Shah, head of EMEA fixed-income sales at Citadel Securities, wrote in a client note, citing cross-asset moves.
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Between the start of the war late last month and mid-last week, shifts in interest rates and the dollar accounted for about 56% of the tightening in financial conditions. Risks assets like stocks contributed the remaining 44%. That dynamic has since reversed, with risk assets driving roughly 61% of the tightening, “suggesting a transition from pricing an inflation shock to pricing growth risks,” he said.
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Bonds slumped this month across global markets as the conflict in Iran triggered the biggest disruptions to oil supply in history. While traders have largely focused on the inflationary impact from higher energy prices, some of Wall Street’s biggest bond managers are increasingly betting yields will decline, expecting a draw-out war drags down growth.
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“As these growth concerns come to the forefront, longer-dated fixed income should start to perform as a hedge to risk assets,” Shah said.
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A protracted war can create “demand destruction” in two different scenarios — either from persistently high energy prices or from central banks tightening policy aggressively to contain rising inflation expectations, he added.
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Shah warned there is little sign of a near-term resolution to the conflict, describing the situation as a “classic escalation trap.” Each side intensifies action in hopes of forcing a retreat, only to provoke further retaliation, he said.
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“Risk markets continue to underestimate the peril of a long conflict without a clear endgame and the impact of a sustained energy price shock,” he wrote.
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