Bond investors, wary of Iran war, turn risk-averse ahead of Fed meeting

By Gertrude Chavez-Dreyfuss

NEW YORK, March 16 (Reuters) - Bond investors have shifted to a defensive stance since the Middle East war injected fresh risk into markets, with many loading up on short-term U.S. Treasuries ahead of the Federal Reserve's monetary policy decision.

On Wednesday, the Federal Open Market Committee is widely expected to keep its benchmark overnight interest rate in the 3.50%-3.75% range at the end of a two-day meeting, as policymakers assess how the Iran war may influence their dual mandate of price stability and maximum employment.

Even with the heightened caution, many investors still believe the conflict will remain short-lived and contained, which is likely to limit the impact of higher oil prices on inflation. Stable consumer prices could give the Federal Reserve room to cut interest rates later in the year, some investors say, which could spark a rally across U.S. Treasuries and much of the broader debt market.

For now though, the combination of geopolitical tensions, sticky inflation and a weakening labor market has muddied the market's view on the Fed's policy direction, portfolio managers say. The uncertainty has also prompted some investors to stay away from longer-term bonds until there is more visibility on how the conflict unfolds and the central bank response.

"Investors are more cautiously positioned and have avoided riskier parts of the bond market," said Danny Zaid, portfolio manager at TwentyFour Asset Management.

"Volatility in rates is going to continue to be high. We continue to be neutral in duration at least until we get more clarity on the conflict."

Duration measures how risky a bond is by estimating how its value will fall or rise when interest rates move. Neutral duration means aligning a portfolio with its benchmark. For example, if benchmark duration is five years, a neutral portfolio would hold securities maturing in around five years. At present, being neutral reflects a cautious stance that avoids longer-term exposure for now.

J.P. Morgan's latest Treasury Client Survey showed that the bank's active clients now hold the highest outright short positions since early February, a move to limit interest-rate risk.

In March, two-year yields have jumped 31 basis points (bps), on track for their largest monthly increase since October 2024, reflecting fears that central banks won't be able to cut rates because of the inflationary impact of higher oil prices. U.S. two-year yields were last at 3.69%.

Many investors see room for two-year yields to fall, reasoning that short-term Treasuries have absorbed the bulk of the selling since the war began, pushing yields to their highest in seven months.

U.S. crude futures have spiked 46% this month, on pace for their biggest monthly gain since May 2020.

TIPPING POINT

"There's a tipping point where the increase from energy-driven inflation becomes demand destruction that starts to reduce consumer spending," said Brad Conger, chief investment officer at Hirtle Callaghan in Philadelphia, which oversees assets from endowments and charitable institutions.

"Treasuries are a hedge against a slowdown in the economy whether the war ends quickly or whether it drags on."

U.S. rate futures have largely stopped indicating that investors expect a Fed cut this year. Markets currently are priced for just 24 bps of easing, down from 55 bps before the war, according to LSEG estimates.

"Rates to me are becoming an opportunity, particularly on the front end of the curve. You're eliminating most cuts in the near term," said Seth Meyer, global head of client portfolio management at Janus Henderson Investors.

That debate over where rates are headed will come into sharper focus on Wednesday, when the Fed releases its summary of economic projections, including the rate forecasts known as the "dot plot."

The "dots" from the December meeting, when the Fed last cut interest rates to the current range of 3.50%-3.75%, showed just one further 25-bp easing this year. The median policymaker's estimate of a neutral level that neither brakes nor stimulates the economy remained at 3%.

Investors overall don't expect much change in guidance from the Fed at the upcoming meeting, with the Iran conflict still raging.

"Determining the next step is anybody's guess at this point," said Olumide Owolabi, head of the U.S. rates team at Neuberger Berman. "I don't see the Fed changing its long-term outlook...just because the level of uncertainty is super elevated."

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(Reporting by Gertrude Chavez-Dreyfuss; Editing by Colin Barr and Andrea Ricci)