ECONOMIC & FIXED INCOME COMMENT - Tug of War for Central Banks

Global growth is expected to remain broadly stable at 2.9% in 2026, supported by strong technology-related investment and the gradual easing of effective tariff rates. However, the escalating conflict in the Middle East is likely to weigh on global growth, with the economic impact depending on five key factors:

1. The length of the conflict, especially how long shipping through the Strait of Hormuz is disrupted and how much global energy supply is restricted, driving prices higher.

2. Countries' net energy trade positions-whether they are net energy importers or exporters-and thus whether they face adverse or favourable terms-of-trade shocks.

3. Energy intensity of GDP, meaning the amount of oil and gas needed to produce one unit of output.

4. The degree of governmental intervention to shield households and firms from higher energy costs.

5. Response of central banks.

   
   

Our base-case scenario assumes tensions in the Middle East begin to ease in the second quarter, while oil prices remain above $90 through mid-year before gradually declining, although staying above pre-conflict levels. Higher oil prices are expected to reduce real incomes and increase business costs, slowing global growth, but a global recession would likely be avoided. If the conflict persists and energy supply disruptions widen, the economic impact could become much more severe.

Oil shocks create challenges for central banks because higher energy prices increase inflation while also reducing demand by eroding real incomes. The key question for policymakers is whether the energy shock will be temporary or persistent. Central banks are expected to respond differently depending on their economic conditions and mandates. The Bank of Japan and the Reserve Bank of Australia are likely to continue raising interest rates, while the Federal Reserve, Bank of Canada, and Bank of England are expected to remain data-dependent. If the conflict continues, differences in monetary policy are likely to widen, with the Federal Reserve having greater flexibility under its dual mandate than the Bank of Canada, whose focus on price stability may limit its ability to respond if higher energy prices continue to increase inflation.

Canadian GDP is expected to remain below trend through 2026, with economic growth projected at 1.1%, as slower population growth, tariff-related pressure on export demand, and weaker business and consumer confidence weigh on the economy. The labour market is expected to remain soft, while core inflation continues moving closer to the Bank of Canada's 2% target.

The U.S. economy is expected to remain stronger, supported by AI-related investment, resilient consumer spending, and the normalization of government operations. As a result, U.S. GDP is forecast to grow 2.2% in 2026.

The Bank of Canada kept its overnight rate unchanged at 2.25%, citing slower economic momentum, a weakening labour market, and near-term inflationary pressures from the Middle East conflict. The Bank will continue balancing these risks while looking through the immediate inflationary effects of higher oil prices. The Federal Reserve also left rates unchanged at 3.75%, while maintaining expectations for further rate cuts in 2026 and 2027, with future decisions depending on continued progress in reducing inflation.

Fixed income markets experienced significant volatility as investors reacted to the inflationary impact of the Middle East conflict. Expectations shifted from additional rate cuts to the possibility of multiple rate hikes, causing bond yields to rise sharply across the yield curve. Despite this volatility, the FTSE Short Bond Index and Mid-Bond Index delivered slightly positive returns for the quarter.