Making sense of the forces driving global markets

By Jamie McGeever, Markets Columnist 

Key equity, bond, currency and commodity prices mostly ended little-changed on Wednesday, as investors digested the fast-moving developments in the Middle East and Federal Reserve's latest policy decision and guidance.

In my column today I explain why the Bank of Japan's cautious approach to reducing its balance sheet will help keep domestic real rates and yields deeply negative, and keep Japanese money overseas. More on that below, but first, a roundup of the main market moves. 

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With the Israel-Iran war entering its sixth day, President Donald Trump leaving the world hanging over his next move and Washington's involvement in the conflict, and the Federal Reserve flagging rising 'stagflation' risks, world markets were remarkably calm on Wednesday.

At least they were calm by the end of U.S. trading, regaining their poise after some intra-day turbulence and settling pretty close to where they ended the previous day.  

In some ways, this was surprising, given the newsflow.

Iranian Supreme Leader Ayatollah Ali Khamenei rejected Trump's demand for unconditional surrender, and the U.S. president said his patience had run out. Asked if he had made a decision on whether to join Israel's bombing of Iran, Trump said: "I may do it. I may not do it. I mean, nobody knows what I'm going to do."

Later on Wednesday the Fed kept interest rates on hold as expected, but officials' revised economic projections pointed to slower growth and higher inflation and unemployment over the next couple of years. Stagflation. 

Trump also resumed his verbal attacks on Fed Chair Jerome Powell before the central bank's policy announcement, calling him "stupid" and berating him for not lowering rates like other central banks. 

On the other hand, there was ultimately little change in the immediate landscape or near-term outlook for investors to price on Wednesday. 

The situation in the Middle East is extremely tense, but no more so than 24 hours ago. Trump's equivocation may fuel the uncertainty and tension, but also leaves the door open to more benign outcomes. Perhaps.

Similarly, Fed officials may think higher inflation risks mean fewer rate cuts are warranted in 2026 and 2027, but they maintained their central forecast of 50 basis points of rate cuts this year. 

Investors could reassess on Thursday. U.S. markets will be closed for the Juneteenth federal holiday, but markets everywhere else will be open and investors will have a raft of policy decisions from other central banks to digest too, most notably from the Bank of England and Swiss National Bank.

The SNB, flirting with negative interest rates again, will be particularly fascinating. Economists expect it to cut rates 25 basis points to zero, and go negative by the end of the year. Traders are attaching a one-in-four chance it cuts half a point on Thursday.

As much of the world frets about the price impact of tariffs, Switzerland is fighting deflation. The franc has never been stronger in broad terms, and its safe-haven status could spur even greater appreciation in the weeks and months ahead. 

The Bank of Japan is taking a more cautious approach to reducing its balance sheet, meaning Japanese capital invested overseas is less likely to be coming home anytime soon.

In the face of heightened economic uncertainty and recent volatility at the long end of the Japanese Government Bond curve, the BOJ announced on Tuesday that it will halve the rate of its balance sheet rundown in fiscal year 2026 to 200 billion yen a quarter. 

The central bank began gradually shrinking its bloated balance sheet 18 months ago and last August began an even more gradual interest rate-raising cycle, representing a historic shift after years of maintaining ultra-low and even negative nominal rates. 

All else being equal, this modest tightening would be expected to narrow the yield gap between Japanese and foreign bonds, making JGBs more attractive to domestic and foreign investors while also strengthening the yen. 

So why hasn't Japanese capital been coming home? In part, because Japan's real interest rates and bond yields remain deeply negative, and the latest BOJ move suggests this is likely to remain the case for the foreseeable future. 

The prospect of Japanese real returns staying deeply negative is enhanced by current inflation dynamics. Inflation in Japan is the highest in two years by some measures and may prove sticky if Middle East tensions continue to put upward pressure on oil prices. Japan imports around 90% of its energy and almost all of its oil. 

Japan's yield curve could also potentially flatten from its recent historically steep levels if the BOJ's decision caps or lowers long-end yields. And the curve will flatten further if the BOJ continues to 'normalize' interest rates - something BOJ Governor Kazuo Ueda insists is still on the table, although markets think the central bank is on hold until next year.