Bond Yields Rise as Oil Prices Add Inflation Pressure

KEY TAKEAWAYS

• Rising oil prices due to the U.S.-Iran conflict could increase inflation and pressure bond markets.
• The 10-year U.S. Treasury yield has climbed to 4.06%, reversing last week’s decline below 4%.
• Investors remain cautious but are treating current oil disruptions as temporary, limiting market movement.

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The bond market stands to take more hits from the escalating U.S.-Iran conflict, as some investors worry a surge in oil and gas prices could rekindle inflation.

Energy prices haven’t spiked to worrying levels yet, but analysts see risks that oil prices will surpass the more than 10% rise already seen since the U.S. and Israeli air strikes in Iran. If higher prices persist, the bond market, which stayed relatively stable Tuesday after a volatile start to the week, could face renewed pressure.

The yield on the benchmark 10-year U.S. Treasury, a key input into mortgage rates, is now up to about 4.06% and at risk of rising higher, analysts say.

“The longer the war continues, the greater the risk of further increases in energy prices, which could keep upward pressure on Treasury rates,” wrote John Canavan, lead analyst at Oxford Economics.

The upside risks mark a shift from last week, when the 10-year yield had dropped below 4%. The decline had pushed mortgage rates down below 6% for the first time since September 2022, making homebuying cheaper.

Why This Matters

Treasury yields influence borrowing costs across the economy, from mortgages to business loans. If oil-driven inflation pushes yields higher, consumers and investors could face tighter financial conditions.

But now investors are debating whether bonds may get hit again. The big risk is a spike similar to that in 2022, when Russia’s invasion of Ukraine led to a surge in energy prices—supercharging the overall rise in inflation after the COVID-19 pandemic.

Iran’s threats to attack tankers have effectively stopped traffic in the Strait of Hormuz, where about a fifth of oil and liquefied natural gas travels. Iran has also attacked refineries and plants in the Middle East, prompting Qatar to halt its massive output of liquified natural gas.

Oil stockpiles in the United States, China and oil-producing giants may provide a buffer, but they will “only help tame the magnitude of the price increase,” wrote Roukaya Ibrahim, chief commodity strategist at BCA Research.

“Investors should not dismiss the risk of meaningful energy market disruptions,” Ibrahim wrote.

Safe Haven Status

Markets don’t seem overly alarmed at the moment. The price of Brent crude oil remains around $80 a barrel, far below the levels of $120 or more in 2022.

“In the event that the march higher in crude prices extends to the $90-$100 range, then the macro narrative would quickly change, especially if prices remain in that zone for months,” wrote Ian Lyngen, head of U.S. rates strategy at BMO Capital Markets.

For now, however, investors seem willing to treat the oil disruptions as temporary—especially given President Donald Trump’s focus on a resumption of traffic through the Strait of Hormuz.

The initial wave of bond-selling “appears to have run its course,” wrote Ian Lyngen, head of U.S. rates strategy at BMO Capital Markets, potentially stabilizing bond yields after their initial rise.

Treasuries may even benefit from investors’ tendency to sell riskier stocks and buy bonds during periods of uncertainty, Lyngen wrote. The connection between bonds and stocks isn’t perfect. The two sold off together in 2020 and during last April’s tariff turmoil, as investors dumped assets en masse.

Bonds’ safe-haven quality wasn’t visible on Monday, since stock markets remarkably ended in the green on the first day of trading following the weekend’s airstrikes. But stocks fell on Tuesday, prompting some investors to buy bonds despite the risk of inflation.

Tuesday’s trading suggests that “safe haven demand for Treasuries remains when geopolitical discord emerges,” he wrote.

But markets haven’t faced a real test yet, wrote Henry Allen, a macro strategist at Deutsche Bank, since the increase in oil prices has been small compared to 2022, the Gulf War or oil shocks in the 1970s.

“We are yet to see an increase in oil prices above +50%, let alone one that is sustained,” Allen wrote, limiting the potential for a sell-off in stocks or a massive repricing of the Fed’s policy outlook.

Fed Outlook

A “sharp, hawkish pivot” from the Fed forced a big sell-off in stocks in 2022, Allen wrote, as the Fed sought to rein in inflation by sharply raising interest rates.

But market expectations for the Fed haven’t moved much, even as some anticipate a small delay in Fed cuts. Much like they did last week, investors still generally believe the Fed will lower rates twice this year, according to the CME Group’s FedWatch tool, which uses futures markets pricing to determine Fed probabilities.

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That’s because many investors anticipate a temporary hit to inflation at the moment, wrote Samuel Tombs, chief U.S. economist at Pantheon Macroeconomics. The conflict “has modest implications for the US economic outlook, for now,” he wrote, pushing up inflation only slightly.

Fed officials said on Tuesday they’re watching the issue closely.

It is “too soon to know” whether the Iran conflict will have a lasting imprint on inflation or will be more temporary, Minneapolis Fed President Neel Kashkari said at an event on Tuesday.

“The question I think that we are wrestling with, and markets are wrestling with, is: How long is this going to last? How bad is it going to get? Is it going to look more like Russia-Ukraine, or is it going to look more like Hamas attacking Israel?” Kashkari said. “That’s going to have effects on monetary policy."

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