An excerpt from the State Street 2Q26 Fixed Income Forecast
From an economic perspective, the shorter the conflict, the more likely that the shock is largely inflationary; the longer it is, the more growth takes a hit. Either way, we do not believe that the dramatic hawkish shift in policy rate expectations is warranted. Central banks can warn about the possibility of rate hikes to combat inflation but we believe the likelihood that they will actually deliver them is still low, even though the sole inflation mandates of many banks (outside of the US) would argue for earlier tightening. Yet the memory of past policy mistakes (especially for the European Central Bank (ECB), whose premature tightening during prior downturns proved ill-advised) should stay most policymakers’ hands enough to allow for a resolution of the conflict.
Any shock that threatens to re-awaken inflation risks would typically send bond investors heading for the hills (and we did see those outflows materialize during the month of March). Yet we find ourselves adding meaningfully to fixed income investments overall. For asset allocators, the question isn’t strictly about bonds; however, and part of the calculus here relates to our lower tolerance for equity risk at present. But markets might well be too pessimistic about the outlook for interest rates. And even if the supply shock and inflationary consequences become more entrenched, those dynamics would eventually damage global economic growth sufficiently that bonds start to behave more like a safe haven again.
From the geopolitical perspective, little is crystal clear but a decent case can be made that forward-looking scenarios are, on balance, supportive of fixed income markets. Especially as major developed market bond yields hover at the upper end of their post-2022 range. In the best case, where we see a quick de-escalation and cessation of hostilities, interest rates likely retrace lower even if only to the middle of the prevailing range—a scenario that appears to be in progress at the time of writing. In a prolonged war, this would keep yields elevated but eventually growth concerns likely lead to self-correcting shifts towards lower interest rates. Perhaps the toughest odds to handicap would be in a dramatic escalation where a case can be made that interest rates jump on additional supply-side inflation shocks; but it’s equally plausible that investors turn to bonds as risk assets lose their appeal. Though we remain underweight fixed income in total, our bond composition is such that we are marginally overweight duration at the portfolio level.
Whether a more benign geopolitical environment is in the offing remains unclear. The US and Iran have reached negotiated resolution to crises in the past— namely through the Algiers Accords which officially ended the Iran Hostage Crisis. Yet a key driver of that agreement from the perspective of Iran was that “the hostages are like a fruit from which all the juice has been squeezed out.”1 Today there is plenty of juice left with respect to leveraging the closure of the Strait of Hormuz. And with such divergent outcomes for markets across potential scenarios that may take shape, we are comfortable holding our equity allocation relatively neutral, our fixed income exposure (duration) close to neutral, while still favoring the commodity complex in a multi-asset portfolio.
- Shaul Bakhash, The Reign of the Ayatollahs—Iran and the Islamic Revolution (1984), page 149.
