Oil price surges trigger bond market sell-off: US Treasury yields nearly flat for the year, with the two-year yield surging to 3.75%

Due to the prolonged and costly prospect of the Iran conflict pushing up oil prices and reigniting concerns about inflationary shocks, US bond prices fell on Thursday, pushing short-term yields to their highest level since August last year. The sell-off triggered by the late surge in crude oil prices swept through the $31 trillion US bond market, putting the year's gains at risk of being wiped out. Traders were already concerned about resurging inflation, economic slowdown, and war spending exacerbating budget deficits, and now further pushing back expectations for the Fed's next rate cut to mid-2027. Subadra Rajappa, head of US rate strategy at France's Industrial Bank, said: "As the market readjusts to the new normal, short-term rates feel somewhat out of control. Rising oil prices, overall inflation, and rising risks of stagflation will put the Fed in a dilemma." The two-year Treasury yield, closely linked to expectations of monetary policy, climbed 10 basis points late Thursday to 3.75%, as crude oil settlement prices reached $100 per barrel for the first time since 2022. This movement pushed the yield above the rate the Fed pays on excess reserves, with traders saying stop-loss orders on direct positions and curve trades may exacerbate selling pressure. Ian Lyngen, head of US rate strategy at BMO Capital Markets, said: "The rise in the two-year rate is no longer about valuation or a fundamental shift in market expectations for monetary policy. Instead, selling is being amplified by the reduction of risk exposures and stop-loss orders for crowded long positions." While the changes on Thursday were most pronounced in shorter-duration bonds more affected by interest rates, yields across all maturities rose, with the benchmark 10-year Treasury yield ending at 4.27%, hitting a new high in over a month. Since the US attacked Iran on February 28th, investors have been demanding higher yields to cope with the spike in oil prices that could lead to resurging inflation, even as the possibility of a Fed rate cut declines due to an economic slowdown. Traders believe there is almost no chance of a rate cut at next week's Fed meeting (current rate range is 3.5% to 3.75%), with a 70% likelihood of only one rate cut this year. Goldman Sachs economists withdrew their forecast for a June rate cut on Wednesday night due to the "rising inflation path." They now expect rate cuts in September and December, compared to previous expectations of June and September. Jack McIntyre, portfolio manager at Brandywine Global Investment Management, said: "Clearly, the market is postponing its expectations for a Fed rate cut this year." In the options market, traders have begun unwinding bullish positions on rate cuts due in June and September, anticipating a decline in expectations during this period. The rise in oil prices and US bond yields on Thursday occurred after Iran's new supreme leader, Mojtaba Khamenei, said the Strait of Hormuz should remain closed and threatened to open a new front if the war continues. This week, companies have also flocked to the bond market to issue new bonds, competing for funds with the US Treasury's monthly auctions of three-year, ten-year, and thirty-year Treasury bonds. As of Wednesday, the Bloomberg US Treasury Performance Index has fallen 1.4% this month, narrowing the year's gain to 0.3%. The yield on US government debt was 1.7% at the end of February. In addition to the transmission of rising oil prices to broader consumer inflation, long-term military operations in the Middle East could require the issuance of more government bonds to fund them. The Supreme Court's decision on February 20th to overturn the tariffs imposed by the US administration last year has already damaged fiscal prospects. These factors have overshadowed the flight to safety in US bonds triggered by weak US stocks (particularly declining confidence in valuations for tech companies) and cracks in the private credit market. Gennadiy Goldberg, head of US rate strategy at TD Securities, said: "The Iran conflict has raised concerns about persistent inflation and the possibility of additional fiscal spending, pushing up yields as expectations for the Fed to remain on hold for longer have increased." The global bond index covering high-quality government and corporate bonds has wiped out its gains for the year. Since March, European government bonds have fallen more than US Treasuries, partly due to their economies being more reliant on imported oil. Strategist Alyce Andres said: "Concerns about rising oil prices leading to inflation, and thus the Fed maintaining high rates for longer, will put pressure on short-term performance."