At the start of 2022, bond investors were already facing the highest inflation rates in decades across most large western economies. Now, following Russia’s invasion of Ukraine last month, which drove commodity prices to their highest level since 2008, inflation well in excess of central bank targets is expected to stick around for even longer.

For central bankers, this economic fallout from the Ukraine war has sharpened a dilemma: how to tackle rising prices without choking off economic recovery from the coronavirus pandemic?

“There’s been a stagflation concern around for a while and, with everything that’s happening in Ukraine, that’s really starting to accelerate,” says Gregory Peters, co-chief investment officer at PGIM Fixed Income, the asset manager.

The US Federal Reserve and the European Central Bank have, so far, appeared to stick to their guns, emphasising the fight against inflation rather than the threat to growth posed by the “oil shock” of the Ukraine invasion.

The Fed last week delivered its first post-Covid interest rate rise by a quarter of a percentage point, to a target range of 0.25 per cent to 0.5 per cent, and signalled it expects a further six increases this year. The Bank of England raised its base rate to 0.75 per cent at its third meeting in succession on Thursday. And even the typically more dovish ECB accelerated the winding down of its asset purchase programme this month, leaving markets braced for higher rates in the eurozone later in the year.

To some investors, that is a sign that central bankers will not come riding to the rescue at the first sign of economic trouble or a setback in stock markets — as they often did in the period after the 2008-9 global financial crisis.

“People have been preconditioned by central banks to ‘buy the dips’ over the past decade,” says Peters. “But with inflation that is still high and has become politicised, I’m not sure you can blithely use the same playbook.”

US short-term bonds yields, which are highly sensitive to interest rate expectations, have charged higher in recent months, with the outbreak of conflict in Ukraine only briefly arresting their rise. The two-year Treasury yield has risen to 1.92 per cent from less than 0.8 per cent at the start of the year.

In Europe, with its greater reliance on Russian energy imports, short-term borrowing costs sank at the start of the conflict but have since rebounded to levels seen in mid-February. Many fund managers believe that the economic fallout from the war will prompt the likes of the ECB and the BoE to move more slowly on rates later in the year.

“The nature of inflation has changed,” says Christian Kopf, head of fixed income at Union Investment, the German asset manager.

“Before this oil shock, we had a mixture of supply- and demand-driven inflation. Now, it’s clearly mainly mainly supply-driven, and that warrants a different central bank reaction,” he argues.

“We have a big shock to activity in the euro area and it doesn’t make sense to hike at the moment.”

The nature of inflation has changed . . . and that warrants a different central bank reaction

In fact, further rises in oil prices, despite their short-term inflationary impact, could actually help to dampen longer-term inflation expectations by sapping the strength of the economy, according to Simon Lue-Fong, head of fixed income at Vontobel Asset Management .

The price of a barrel of Brent crude has surged close to $130 from less than $80 at the start of the year. Last Thursday, it traded at just under $105. “The longer the oil price stays high, the more damage it will do to growth or inflation expectations,” Lue-Fong says.

Even before the outbreak of the Ukraine conflict, bond investors were questioning how far central bankers would be able to tighten policy without snuffing out the recovery. Longer-term bond yields have also risen in recent months, but their ascent has been much more modest than that seen in, for example, two-year debt. The US 10-year yield trades at 2.15 per cent, up from a little over 1.5 per cent at the end of 2021.

This so-called flattening of the yield curve — where the gap between short-term and long-term yields shrinks — is even more pronounced in the UK and is often seen as a market signal that growth is set to slow.

Many investors think an inversion of the yield curve — where long-dated bond yields fall below short-term interest rates — is possible later in the year if central banks go ahead with a series of rate rises. An inverted curve can indicate that investors expect the central bank will be forced to cut rates due to an impending downturn and has, for decades, been a reliable predictor of recession.

“What the market has been telling you quite clearly over the past six months is that we are careering towards a policy mistake, and that looks even more likely now,” says Peters. “I’m not trying to say central bankers are stupid — it’s just incredibly difficult to get this right.”