Front-ends for value

Why central banks are staying put while markets move

The financial world is currently witnessing a classic central banking paradox: sometimes, the most effective action is to do absolutely nothing. This week, more than 20 central banks – including every member of the G7 – will convene to discuss interest rate decisions. The consensus is clear for the developed market central banks: most, if not all, will choose to leave rates exactly where they are. However, “holding pat” should not be confused with “standing still.” Beneath the surface of these status quo decisions, the landscape has shifted significantly since these committees of central banks last met.

Looking through the inflation “bump”

What distinguishes this round of meetings is a fresh inflation shock. Regardless of their individual mandates or regional contexts, central bankers are grappling with identical concerns: the duration of the conflict in the Middle East, and what it means for the length of time that passage through the Strait of Hormuz will remain restricted.

Market expectations are no longer pricing in a fleeting skirmish. Bolstered by real-time data and prediction markets, the narrative is shifting toward an “attritional” conflict – one where the economic impact could be long-lasting. For a central banker, this means moving beyond simple forecasts to sketching out scenarios, some of them complex, and attaching probabilities to various outcomes.

In the “real” world, this heightened uncertainty manifests as deferred consumption, stalled investment, and a surge in precautionary saving. Consequently, while near-term inflation expectations are seeing a “bump,” the long-term outlook for growth and employment is being revised downward.

A transatlantic divide

We are observing a distinct “hawkish tilt” in near-term rate expectations, as markets price out previously anticipated cuts and, in some instances, increase the probability of hikes. While the challenges are global, the market reactions are increasingly regional.

Our chart focuses on three key central banks that all have decisions this week – the Fed, Bank of England and ECB.

Divergence is most visible when comparing the U.S. with Europe (ie both Eurozone and UK). While the market has removed anticipated cuts for the U.S. Fed, it still expects rates to settle near neutrality. In contrast, the UK and the Eurozone have seen dramatic shifts. Two-year forward cash rates in these regions are 72bp and 57bp higher, respectively, than they were just 17 days ago. From the end of February the two-year US forward rate is 39bp higher but this reflects pricing-out of cuts, not hikes.

The UK and Eurozone now stand out for their hawkishness, with as many as two hikes priced in and a projected “resting place” for rates that sits comfortably above neutrality.

Understanding the “neutral” anchor

To measure this shift, we look at the market’s assessment of policy rates two years from now relative to the “neutral” rate. While the validity of these neutral rates is often debated, they serve as a useful reference point for anchoring market changes. In our analysis, we use central tendency numbers for equilibrium: 3.0% for the UK and US, and 2.0% for the Eurozone. These figures help us see that the rising lines in our chart aren’t just noise; they represent a genuine increase in hawkishness compared to previous expectations.

Where is the trade?

For investors, the most compelling takeaway is that value has returned to the “front-end” of the market.

Coming into this conflict, front-end maturities were underperforming.  Since the start of February, 2-10 year curves have flattened significantly – by 17bp in the US, 21bp in the UK, and 23bp in the Eurozone. This flattening may also represent a reversal of the previous consensus. Instead of positioning for a “steepening” of the curve, the smarter move may be to buy short-dated bonds that now yield more than official policy rates.

In the Eurozone, two-year yields for German, French, and Italian debt (2.43%, 2.60%, and 2.67%, respectively) all sit comfortably above the ECB’s 2.15% reference rate. While additional yield is often a reflection of credit risk, for these sovereigns, that risk remains minimal. It’s just about rates.

The UK’s “Maradona effect”

The UK front-end is perhaps the most pronounced opportunity. Two-year UK gilt yields are currently at 4.12% – the highest in the developed world outside of Australia, where the central bank was already on a tightening path. This is already significantly above the 3.75% policy rate and more than 100bp above neutral estimates.

This market behaviour mirrors what former Governor Mervyn King called the “Maradona Effect”. Much like the legendary footballer’s feints, the forward markets are doing the “work” for the central bank by implying a tightening that may never actually happen.

Conclusion: The case for short-dated bonds

Central banks have every reason to “sit on their hands” while they analyse the shifting geopolitical sands. Meanwhile markets move in real time, and investors don’t have the luxury of waiting for energy prices to normalise.

With heightened uncertainty, short-dated bonds are acting as a safe haven. They offer a way to de-risk from equities and credit while providing yields that are far more attractive than traditional current accounts from banks. The “hawkish” market repricing has restored value to the front-end, suggesting that for those looking for entry points, there is no need to wait.