Oil Price Surge Creates New Mystery in Bond Markets: Inflation Trade Winds Down, Recession Concerns Quietly Emerge?

According to Cailian Press, as inflation concerns triggered by the Iran conflict gradually intensify, bond investors are beginning to consider a deeper question: Will rising oil prices eventually pose a threat to economic growth?

Currently, crude oil prices have risen to their highest levels since the last major linkage between U.S. Treasuries and oil during the Russia-Ukraine conflict in 2022, making inflationary pressures the top risk in investors’ eyes. It is expected that this will also be a key focus for Federal Reserve officials at this week’s policy meeting.

However, as the conflict enters its third week, market expectations for Fed rate cuts are waning, and more people are discussing whether soaring energy prices, amid signs of fatigue in the labor market and consumer spending, will ultimately backfire on the economy. Priya Misra of JPMorgan Asset Management believes that, in this context, the yield on the 10-year U.S. Treasury has become attractive, rising from 3.94% at the end of February to over 4.25%.

“You never want to catch a falling knife,” said the portfolio manager. “But when markets have undergone significant re-pricing and positions are cleaner, it might be a good time to position for a ‘growth shock’—which often follows inflation shocks.”

Misra’s view captures the tension brewing in the bond market: whether to respond immediately to initial oil price increases or to anticipate their subsequent impact on economic growth. The market is caught in a dilemma.

This debate over which force will dominate the market could shape the core trading logic of U.S. Treasuries in the coming months—implying potential upside for the market, prompting traders to price in more Federal Reserve easing, which could push yields lower again.

March Reversal

This month’s sell-off in U.S. Treasuries marks a significant shift. In February, concerns about artificial intelligence (AI) potentially disrupting certain industries had supported bond prices.

Since the U.S. and Israel launched strikes on Iran and Iran retaliated, inflation worries have taken center stage. Last week, Brent crude oil closed at around $103 per barrel, up about 40% since the end of February, adding further pressure to already high inflation.

The surge in oil prices has put the Fed in a dilemma—having failed to meet its 2% inflation target for five consecutive years. Dario Perkins of TS Lombard notes that while not every major oil shock leads to recession, the most severe U.S. recessions—1974, 1981, 1990, 2001, and 2008—occurred after energy prices spiked suddenly.

Morgan Stanley strategists told clients last Friday that U.S. Treasuries “are now positioned for a reversal driven by demand destruction.” They are examining when oil prices might trigger a cooling rather than a heating of inflation through the use of one-year forward inflation swap rates.

“Once rising oil prices no longer push up the 1-year/1-year inflation swap rate and instead cause it to decline, we believe investors should increase their holdings of Treasuries,” they said.

Macro strategist Edward Harrison commented, “After supply disruptions, the oil market needs to rebalance, and prices must rise enough to force demand down. But demand decline depends on economic activity slowing and growth weakening. This is a classic stagflation shock, and it’s still unclear whether slowing growth or rising inflation will dominate.”

At this week’s Fed meeting, markets will closely watch whether officials stick to their forecast of one rate cut in 2026 made last December.

The swap market currently expects less than one full rate cut from the Fed this year, whereas two weeks ago, expectations included up to three cuts. Data from the Atlanta Fed shows that options pricing even indicates a more than 20% chance of rate hikes before December.

Barclays strategists believe the market may be underestimating growth risks. Last week, they recommended a series of bullish bond positions, including long positions in December 2027 short-term interest rate futures, betting that the Fed will implement more easing than the market expects.

James Athey, portfolio manager at Marlborough Investment Management, said he has increased his U.S. bond exposure after recent sell-offs and believes rate cuts by the Fed may be delayed but not canceled.

“We are indeed facing more severe consequences from rising oil prices,” he said. “If things develop in this direction, I don’t see it as an inflation shock—this is the market’s current pricing logic—but rather as a growth shock driven by risk aversion.”

Overall, financial markets have yet to signal significant growth concerns, with the S&P 500 only about 5% below its January all-time high.

A 2024 Fed study found that the surge in oil prices following the Russia-Ukraine conflict pushed up overall inflation but had limited impact on core inflation and overall economic activity, partly because energy accounts for a relatively small share of U.S. production and consumption.

But the key question is how long oil prices will stay high. With U.S. President Trump and Iran’s new Supreme Leader Mullah Khamenei showing tough stances last week, the threat of sustained high oil prices is rising. In a context where the economy is already showing signs of stalling, this undoubtedly increases risks.

John Briggs, head of U.S. interest rate strategy at Natixis North America, said that given data showing U.S. employers cut jobs in February and unemployment rose, the market is underpricing the probability of the Fed easing policy before June.

He believes that the two-year Treasury yield, around 3.7%, which is above the effective federal funds rate, has entered an attractive buying zone.

“Gradually building a position in two-year Treasuries is worthwhile because it should benefit from downside growth risks,” he said.