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

As concerns about inflation 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 Russia-Ukraine conflict in 2022—when U.S. Treasuries and oil were last highly correlated—making inflationary pressures the top risk in investors’ eyes. It is expected that this will also be a key focus for Federal Reserve officials during 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 repricing 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: Is the market reacting to the initial rise in oil prices, or is it anticipating subsequent impacts on economic growth? The market is currently at a crossroads.

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

March Reversal

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

Since the U.S. and Israel launched strikes on Iran, and Iran retaliated, inflation fears have taken center stage. Last week, Brent crude oil closed at around $103 per barrel, up about 40% from 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 achieve 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.

Last Friday, Morgan Stanley strategists told clients that U.S. Treasuries “are now positioned for a reversal driven by demand destruction.” They are using one-year forward inflation swap rates to gauge when oil prices might trigger a cooling rather than a rise in inflation.

“Once rising oil prices no longer push up the 1-year, 1-year inflation swap rate, but 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 to decrease. 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.”

This week’s Fed meeting will be closely watched to see if 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 this year, whereas two weeks ago, the expectation was for three cuts. Data from the Atlanta Fed shows that options pricing even indicates a greater 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 going long on December 2027 short-term interest rate futures, betting that the Fed will implement more easing than the market currently expects.

James Athey, portfolio manager at Marlborough Investment Management, said he has increased his U.S. bond exposure after recent sell-offs and believes that 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 major 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’s share in U.S. production and consumption is relatively small.

But the key question is how long oil prices will stay elevated. With U.S. President Trump and Iran’s new Supreme Leader Mullah Khamenei taking hardline stances last week, the threat of sustained high oil prices is rising. Against a backdrop of signs of economic slowdown, this undoubtedly increases risks.

John Briggs, head of U.S. rates 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, is in the buy zone.

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