Bond Market in Oil’s Grip Ponders Shifting Focus to Growth Worry

fgrg353)kt}02ebimpn0ij)c_media_dl_1.png Bloomberg

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(Bloomberg) — Bond investors are starting to ponder whether the inflation worries sparked by the Iran war will soon tip over into concern about the risk to economic growth from elevated oil prices.

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For now, with crude around the most expensive since the aftermath of Russia’s invasion of Ukraine in 2022 — the last time US Treasuries and oil were correlated this closely — the threat of hotter inflation is top of mind for investors. And it will likely be for Federal Reserve officials as well when they meet this week. 

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However, as the war enters its third week, with bets on Fed interest-rate cuts fading, chatter is building around the prospect that soaring energy prices will eventually depress the economy, at a time when the labor market and consumer spending are already showing cracks.

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Against that backdrop, Priya Misra at JPMorgan Asset Management says 10-year yields at or above 4.25% — up from 3.94% at the end of February — start to look appealing.

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“You never want to catch a falling knife,” said the portfolio manager. “But when the market has done a lot of that repricing, positions are cleaner, this might be the time when you position for that growth shock that typically follows the inflation shock.”

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Misra’s stance captures the tension that’s building in the bond market, between reacting to the initial oil jolt and anticipating the extent of any subsequent hit to growth. 

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The debate around which dynamic will prevail is potentially setting up the defining trade in Treasuries over the next few months, as it suggests there’s scope for a bullish shift that forces traders to price in more Fed easing, dragging yields down again.

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March Turnaround

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This month’s selloff marks a big turnaround for Treasuries, which rallied in February in part on concerns that artificial intelligence could disrupt some industries.

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Inflation fears have become paramount since the US and Israel launched strikes on Iran, and as Iran retaliated. Brent oil, the global benchmark, was around $103 at the end of last week. That’s up about 40% from the end of February, adding pressure to already hot inflation. 

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That jump puts the Fed — which hasn’t met its 2% inflation target for half a decade — in a bind. While not every major oil shock has preceded a recession, the most serious US economic downturns have followed a sudden spike in energy prices – including in 1974, 1981, 1990, 2001 and 2008, according to Dario Perkins at TS Lombard.

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Morgan Stanley strategists told clients on Friday that Treasuries are “ripe for a demand-destruction-induced reversal.” They pointed to the 1-year forward 1-year inflation swap rate for clues as to what oil price might lead to cooler, not hotter, inflation.

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“Once higher oil prices no longer lead to higher 1y1y inflation swap rates, but rather lower rates, we think investors should go overweight US Treasuries,” they said.