The next piece of the puzzle

The week starts with a surprise development in the Middle East – or rather, the lack thereof. The US has halted its attacks on Iran since Friday without explaining why, and Iran has said it won't retaliate further. US crude kicked off the week with a more than 8% retreat, though it has pared a small part of those losses as traffic through the Strait of Hormuz remains near a standstill and Yemeni Houthis reportedly targeted Saudi Aramco's facilities.

The geopolitical situation remains highly uncertain and risks are still tilted to the upside for oil prices. But the calmer weekend and the pullback in energy prices this Monday are supporting bond demand in the early hours of the week. The Japanese 10-year yield is back below 2.80%, while the US 2-year yield, which reflects Federal Reserve (Fed) rate expectations, is down 5bp in Asia.

The Fed will meet this week and is expected to leave rates unchanged. Activity in Fed funds futures assigns around a two-thirds probability to that scenario. But because the Fed is changing its communication and guidance strategy under the new Chair, Kevin Warsh, a surprise 25bp hike this Wednesday wouldn't come as a huge surprise. The fact that the latest inflation figures came in softer than expected could encourage the Fed to kick the can down the road until September. But the fact that energy prices have been rising again, with no easy resolution in either the Middle East or Ukraine, suggests that the Fed will deliver that rate hike sooner rather than later. I still think September is the better time for action – the summer months tend to see thinner liquidity and amplified market reactions. But whatever the Fed does, the accompanying statement will likely remain cautious, hinting at multiple possible scenarios that will depend on macroeconomic and geopolitical developments, as well as incoming economic data.