High oil prices difficult to shake the bond market's "defection", US bond trading logic quietly turning towards growth concerns.

With investors' concerns deepening that the energy crisis will prompt the Federal Reserve to raise interest rates, and instead chasing US Treasury yields that hit year-to-date highs, the selling momentum in the US bond market has temporarily stalled. On Friday, benchmark US bond yields retreated after climbing to their highest levels since mid-2025. The two-year yield, most sensitive to changes in Federal Reserve policy, briefly dropped 9 basis points to 3.90%, after hitting a June high of nearly 4.03%. Despite crude oil prices hitting multi-year highs, the bond market saw a rebound, breaking the recent pattern of correlation between the two. Over the past month, investors have largely ignored the drag on the economy from rising fuel costs, instead pushing yields higher due to increasing inflation expectations. Ian Lyngen, head of US rate strategy at BMO Capital Markets, stated, "The front end of the US bond yield curve is no longer tracking energy prices as an inflation risk factor, but is focusing more on the downside pressure on economic growth and risk assets." Longer-term bond yields also retreated from their year-to-date highs. The 10-year US Treasury yield rose nearly 2 basis points to 4.43% on the day, after briefly surpassing 4.48% for the first time since July. As oil prices continued to rise due to US military action against Iran (now in its fifth week), yields across different maturities briefly reached daily highs. Despite WTI crude oil futures closing at $99.64 per barrel, the highest level since mid-2022, short-term bond yields remained near their daily lows. Global benchmark Brent crude oil also closed at multi-year highs. The resulting steepening of the yield curve breaks the pattern of recent months where rising oil prices accompanied a flattening curvewhen investors expected the Federal Reserve to react to rising inflation. In a report released on Friday, Lyngen said that the market's recent movements signal an imminent turning point, where the "mechanism to respond to further oil price increases will change," shifting to push the yield curve steeper. Since the US attacked Iran on February 28, disrupting oil supplies in the region, US bond yields have risen alongside oil prices. Late on Thursday, US President Trump extended by 10 days the pause in attacks on Iranian energy facilities, causing yields and oil prices to briefly dip, but he expressed doubts about the possibility of reaching a peace agreement. The rise in yields reflects concerns that the increase in US retail gasoline prices could show up in overall consumer inflation measures, hindering the Fed from implementing rate cuts widely expected before the conflict erupted. John Briggs, head of US rate strategy at French investment bank Natixis, said that as long as the Strait of Hormuz remains closed, investors will worry about "inflation and the central banks taking measures similar to those in 2022." The oil shock caused by the 2022 Russia-Ukraine conflict led to a surge in inflation after the pandemic, ultimately resulting in the Fed raising rates by over five percentage points by mid-2023. Macro strategist Michael Ball said, "The next likely move for the US bond yield curve is steeper, led by a potential reversal in front-end yields. Front-end yields had priced in oil-driven inflation more aggressively, while underpricing the impact of rising energy costs on growth and the labor market." While expectations for future year-over-year inflation have slightly retreated from their recent highs, they have surged from about 2.2% at the beginning of the year to over 3%. Swap contracts reflecting expectations for future Fed rate decisions no longer show any possibility of rate cuts this year, pricing in a probability of over 50% for rate hikes. Molly Brooks, rate strategist at TD Securities, said, "The market has completely shifted from questioning when the next rate cut will come to pricing in rate hikes for 2026." The Federal Reserve cut rates three times last year to address weak labor market conditions. While those concerns have largely abated, February's job data was weaker than economists had anticipated. The March jobs report will be released next week on April 3 amid an unusual market environment as the stock market will be closed for Good Friday (not a federal holiday). The bond market will have shortened trading hours due to the holiday (if it does not coincide with the release of important economic data), giving investors a limited timeframe to react to the data. The market's movements on Friday suggest that the US bond market is poised to record one of its worst months in nearly five years. According to relevant US bond indices, as of March 26, the US bond market has fallen 2.36% this month. If this decline is maintained, it will be the worst-performing month since October 2024. Citigroup economist Andrew Hollenhorst wrote in a report that the upward pressure on US bond yields also stems from the prospects of increased government borrowingboth to finance the costs of war and to refinance existing debts at higher rates. This week's auctions of two-year, five-year, and seven-year US Treasury notes all cleared at higher-than-expected yields, reflecting investors' demand for average rate levels needed to meet the US government's financing needs. The three auctions together raised $183 billion. This was the worst performance in a month for these three term varieties since May 2024, when traders were also reducing their bets on rate cuts. Hollenhorst wrote that the bond auctions "serve as a reminder that fiscal challenges will intensify as rates rise," and pointed out that "during an expected period of rate cuts by the Fed, it is easier to finance a large deficit," while the current "expectations for defense spending are rising."